Life Insurance and Estate Planning

While it’s true that you can’t take it with you when you die, you still need money when you pass away. Many people work hard their entire lives to build assets, with the intent to eventually pass on an inheritance to their loved ones. A will is a good starting point, provides a roadmap for planning your estate, and should be updated on an ongoing basis.

However, even if you have a will, it is your executor’s responsibility to file a tax return for you and the government will consider you to have sold all your assets at their full value just prior to your death, which could lead to a large tax bill. Part of the tab on that final tax bill could include such items as:

  • Probate fees on bank accounts and your primary residence
  • Income taxes on registered retirement savings plans (RRSPs) or registered retirement income funds (RRIFs)
  • Capital gains taxes on a family cottage, condo in Florida, or rental property, or
  • Capital gains taxes on a stock portfolio or shares in a business.

Taxes could reduce the value of these assets between 25% to 50%. Simply put, without proper planning, the government of Canada could end up being one of your largest beneficiaries.

Let’s talk about how life insurance can help in these situations.

Life Insurance and Estate Tax Planning: How to Use it?

While you can give away or gift cash or certain possessions while you are still alive, or set up joint tenancy arrangements, it requires you to give up control of those assets when you may still need and want those assets to live your life to the fullest. This is where life insurance can be a very practical, alternative solution. Life insurance is a unique financial instrument that can create an instant estate at the stroke of a pen and provide the needed cash to cover those final expenses. As compared to setting aside funds over many years in an investment savings account, or forcing your loved ones to sell an asset, or borrow the money when the time comes, a life insurance policy is usually the most cost-effective way to pay the tax. That is why the topic of life insurance and estate tax planning captures a lot of interest. The annual life insurance premiums can work out to pennies on the dollar, as a percentage of your overall estate.

Single Life vs Last-to-Die Policy: Which One Makes More Sense for Estate Planning?

If you’re married, a common strategy usually involves a rollover or transfer of your assets to your surviving spouse. As a result of this rollover, what’s referred to as the deemed disposition and calculation of the final tax bill will be deferred until the death of the surviving spouse. Consequently, these policies are usually set up on a joint last-to-die basis, to time the payout of the insurance proceeds when the taxes are due. Insurance company actuaries calculate premiums on joint last-to-die policies with a discounted premium of up to 40 per cent as compared to a single life policy, since both spouses need to pass away for the proceeds to be paid out.

Whole Life vs Universal Life: Which One is a Better Fit for Estate Planning?

The primary consideration in selecting an insurance product for estate planning is that it is first and foremost a permanent policy. While all life insurance policies are designed to pay a benefit when someone dies, there are different types of policies to meet different needs.

Temporary or term insurance is generally designed for a temporary need. It pays a benefit only if you die during the term (such as 10 or 20 years) and when the coverage ends you may or may not qualify for new coverage (depending on your health) or because of your age, the cost of continued coverage may not be affordable, or the plan may contractually terminate by average life expectancy, which is typically age 80 or 85 with most insurers.

The exception is Term to 100. This is a type of term policy with fixed premiums to age 100 at which point the policy becomes paid up. This would be considered a permanent policy and suitable for estate planning purposes.

The other types of permanent policies available are either universal life or whole life. Both usually have fixed premiums and can be paid monthly or annually for life or pre-paid earlier over 10 or 20 years. Both also build cash value. Like owning a home, they require a larger payment, but provide you the opportunity to build “equity” in the policy, which grows tax deferred. This means money can grow funds faster than in a taxable investment with the same return and expenses.

Universal life can be less expensive and more flexible, as it enables you to pay just the cost of insurance or deposit in excess of the minimum cost of insurance into a “self-managed” investment account. The insurer would provide a menu of various investments in asset categories like equities and fixed income including stock market indices, mutual funds, bonds, and GICs. These investments would have the same volatility of a conventional portfolio, transferring the management and risk of the policy’s performance to the policy owner. Universal life policies are more popular with hands-on investors and policy owners wanting premium deposit flexibility.

Policy owners who are not interested in the day-to-day management of the investments within their life insurance policy may prefer a participating whole life policy, which uses a bundled premium approach combining both the cost of the insurance and investment together. The assets are invested into the participating account asset pool managed by the insurer and can benefit from the expertise of the insurer’s investment division. Premiums go into an account called the participating account in combination with funds from other participating life insurance policies, using a long-term investment strategy that produces an annual dividend scale interest rate. Along with other factors such as expense management and product profits, dividend payments are primarily determined by the investment returns earned in the participating account. Through an investment approach that emphasizes a stable, conservative portfolio which smooths the impact of short-term volatility, dividend scale interest rates are able to maintain a relatively stable, long-term annual average return in the five to six per cent range with the larger insurers.  

Corporate vs Personal Life Insurance Policy

This is a complex subject and needs to be evaluated on a case-by-case basis. Generally, if an insured individual owns shares in an incorporated business, owning a policy corporately may make good business sense and provide advantages as well. But, it’s important to examine the pros and cons to make sure that an advantage now does not become a drawback later. In general, life insurance premiums are paid for with after-tax dollars. A corporation that is a Canadian controlled private corporation (CCPC) and is eligible for the small business tax deduction may pay tax at a lower rate than the insured shareholder personally. If so, the corporation will not need to earn as much money as the insured to pay the premiums.

For example, John owns a CCPC and the life insurance monthly premium is $250 per month. His personal effective marginal tax rate is 48 per cent and his corporate tax rate is 12 per cent. To fund the policy premiums personally, John needs to earn $481 each month pre-tax by way of salary or dividends in order to net $250 after tax to pay the premiums, while his corporation would only need to earn $284 before tax to fund the $250 premium, equating to a net savings of $197 each month.

Business owners would also benefit from the tax-deferred growth in the value of the investments in an exempt permanent life policy. This benefit is comparable to the investment growth in a registered retirement savings plan or a tax-free savings account (TFSA) by potentially allowing for greater investment growth because the earnings can accumulate free from tax. As well, in 2019, the government introduced new rules restricting access to the small business deduction limit for corporations that earned more than $50,000 of passive investment income and eliminating it completely when investment income reaches $150,000, resulting in a tax increase on active income to the general business rate. Since life insurance is tax exempt, the cash value investment portion is not affected by the new tax and including it as part of the corporation’s investment portfolio can help reduce the new passive tax.

Another benefit of corporate owned life insurance is that a significant portion of the proceeds are added to the company’s capital dividend account (CDA). The CDA is a special corporate notional account that gives shareholders designated capital dividends, tax-free. A company that receives life insurance proceeds in excess of the cost basis of the life insurance will have the excess amount added to the CDA balance for the surviving shareholders.

While there are many benefits and flexible planning opportunities when purchasing and using life insurance through a private corporation, there are a number of additional complexities to consider including shareholder agreements for partners, if the insured leaves the company or sells his or her interest in the company, the potential exposure of the policy to claims of the corporation’s creditors, the potential loss of the capital gains exemption, and other corporate tax implications. Some of these issues can be addressed through the use of investment holding companies, but the insured should consult their accounting, tax, legal and insurance advisors to ensure the planning is done correctly and that all issues have been addressed.

Are life insurance premiums tax deductible in Canada?

Unfortunately, the answer is generally no. Life insurance premiums are typically not tax deductible in

Canada. When life insurance is used in a business setting, there may be some confusion over whether the premiums are deductible since other types of insurance premiums (property and liability), for example, can be deductible business expenses.

However, there are exceptions. The most common being policies assigned as collateral security for a loan to a financial institution. The loan must come from a financial institution, such as a bank, trust company, credit union or insurance company, not from a source that isn’t in the business of lending money, like a relative or friend. As well, the financial institution must require, as a condition for granting the loan, the collateral assignment of it as a life insurance policy owned by the borrower; and, the borrower and the policy owner need to be the same. Once the policy is assigned, the policy owner may deduct the lesser of the premiums they continue to pay and the pure annual cost of an insurance policy (NCPI-Net Cost of Pure Insurance). The NCPI is used for certain tax purposes and to calculate it, the insurance company uses a formula in the regulations under the Income Tax Act and the NCPI, and the deduction generally increases as the insured ages.

How should life insurance fit in with other assets as part of an overall estate plan?

An estate plan is essential for organizing your financial affairs and ensuring your loved ones will get the most out of the assets you’ve set aside for them. While a will makes sure you don’t forfeit your say on how things are divided and who’ll be in charge of the process, your estate plan minimizes the amount of taxes you have to pay. Assets like RRSPs, RRIFs, TFSAs, bank accounts, stock portfolios and proceeds from the sale of real estate may have to go through probate, a process by which a provincial court confirms the validity of your will and that requires the payment of fees. Potentially, probate can be quite time consuming, tying up assets for months or longer. Beyond the probate fees (up to 1.5 per cent of your entire estate depending on the jurisdiction) that must be paid to the provincial government before your executor can begin to administer your will, there are also additional fees payable to the executor for administration services and for legal and accounting services. In the end, the cost of probate can be significant and time consuming. In addition, as outlined earlier, there is also the final income tax bill on your assets calculated at their full value just prior to your death.

The inclusion of life insurance as part of your assets ensures a cash benefit is paid quickly at the precise time the money is needed. A life insurance policy as an integral part of an estate plan can be a sensible way to help organize your financial affairs and help control how you want your assets preserved and distributed for your loved ones.

Author’s Background:

Eric Benchetrit is a financial services industry consultant and thought leader, considered by his peers as one of the most informed and knowledgeable authorities in his space, providing financial advisors, life insurance agents and related industry professionals expertise in complex tax and estate planning. Eric’s business approach uses a relentless commitment to professionalism and attention to detail, using a collaborative and integrated planning style that works in conjunction with a client’s entire advisory team. His communication style describes complex structures in easy-to-understand terms. He has been in the financial services industry for over a quarter century in a variety of roles, including marketing and distribution at the executive and wholesaling level for insurance companies and Canadian investment firms. He’s also been a faculty member for Seneca College’s Financial Services Practitioner certification program, whose graduates receive credits towards CFP (Certified Financial Planner) and CLU (Chartered Life Underwriter) designations. He’s been involved in many speaking engagements at industry events over the years and has also appeared on radio programs and call-in shows. He has written articles and has been quoted and profiled in several industry publications. He has co-chaired Canadian and international delegations meeting Prime Ministers, parliamentarians, congressman and senators, and holds a Specialized Honours B.A. from York University. He is married with two children, lives in Thornhill, Ontario, and is a very active member of his community, being recently honoured for volunteering his time and sitting on the boards of multiple charitable and non-profit organizations.