I’m involved in two study groups, and, as of last Wednesday, an accountability group as well. One of my Study Groups is international based with my MDRT friends. Last call, one of our study group members from Ontario was doing a presentation on tax changes that were coming through to Canada. He started off by saying that every time Canada gets a new Prime Minister with a fancy haircut, tax laws change.
Despite my general aversion to change, these new rules change make sense. On a basic level, they’re designed to update lifetime insurance products to reflect a reality of longer life expectancies. In this column we’ll specifically look at permanent life insurance and annuities, what they’re used for, and how the tax law changes will impact their application.
Permanent life insurance policies typically come with locked-in premiums. If you want your life insurance to be in-force when you die, than this is the type of policy for you. As well as static premiums, permanent policies are also known for the ability to over-fund the policy and build up an internal investment component.
Why would you want to pay more for a life insurance policy than you absolutely have to? One very good reason: tax. Or, more correctly, the lack thereof. Permanent policies are the original Tax Free Savings Account. The over-funded portion of the premiums that is allocated to an investment component is allowed to grow tax-free for so long as the investments are within the policy.
In general, there are three ways to get the investments back out of the policy. The first is that they can be used to pay the policy’s premium, which is more tax-efficient than using your own personal dollars. The second option would be to borrow the funds back out of the policy. Borrowing has an interest cost, but depending on your economic resources; paying interest can actually end up being more cost effective than the alternative of paying tax. And the third way, quite simply, is to claim on the policy. The investment component of the insurance policy (depending on how the policy was originally set up) becomes part of the death benefit, and death benefits are tax free.
Now let’s add a second layer to this to make it a bit fancier. Lets say that the person looking at purchasing the insurance policy owns a private corporation, and instead of pulling out salary and building RRSPs, this investor chose to build their investments inside of their corporation. We recommend this strategy fairly often.
In this case, since the cash inside the corporation would pass through to the family anyways, and since Corporations can’t have Tax Free Savings Accounts (because they’re not people), a permanent life insurance policy is the only TFSA the corporation can have.
Just like personal TFSAs, corporate life insurance policies don’t just end with tax-free growth, we can actually achieve a tax-free distribution as well. Normally, money taken out of a corporation has tax consequences. Sometimes pretty severe ones. To help offset this, we introduce the Capital Dividend Account, or CDA. The premise of a CDA is that any money received tax-free to the corporation (such as life insurance proceeds) should pass tax-free to the shareholders tax-free as well.
Now bear with me here because thing are going to get extra-fancy and even less taxy. So we’ve got this life insurance policy inside the corporation, and we’re building money inside of it with the intention of borrowing out of it to fund lifestyle expenses, and then passing the remainder tax-free to our heirs on death. Still with me here? Good.
Next we’re going to make a change to the way the insurance policy is funded. Instead of using corporate cashflow or distributions from cash-equivalent investments already inside the corporation, we can build in an annuity. An annuity is basically a tax-efficient lifetime GIC that pays a bit better than retail GICs. How much better varies depending on your age and the amount, but let’s say as an example that the annuity income is about twice that of a GIC with about the same amount of tax owing. By replacing the cash-equivalent corporate investments with an annuity, our tax costs stay the same, but we’ve created extra income that can be used to fund the permanent insurance policy.
Ah, but there’s a catch. The income from the annuity only continues for life. Once you die, anything left from the original investment is forfeited.
Which sounds like a terrible plan. Except that since we used the extra income from the annuity to fund the life insurance policy, the event that causes the annuity balance to be forefitted is the same event that triggers a benefit under the life insurance policy. Since both annuity income and life insurance premiums increase dependent on your age when the strategy is put in place, as a pairing they can work together very well.
Hooray! We’ve built in some advanced professional planning techniques, made it easier to meet your goals, and saved a whole bunch of tax!
Except, oh no! What did we start saying at the beginning of the column? Right. That’s new tax code coming. And it’s got a fancy haircut.
So one of the things about “an insurance policy death benefit credits the CDA so that you can take the death benefit out of the corporation tax-free” needs to be clarified. The only amount that actually credits to the CDA is the difference between the original cost of the policy and the amount of death benefit received. Normally the costs of the policy are more than trumped by the value of the death benefit received, so this isn’t too big of a deal.
Except that as of January 1, 2017, an adjustment is being made to the calculation to reflect the longer life expectancies of Canadians. Which means that as time goes on, more of the premiums are going to count towards costs, resulting in less of the death benefit being able to credit the CDA, and therefore less tax-free cash from the corporation.
The second side of this is that longer life expectancies are also having an impact on annuity calculations as well, making their income less tax favorable (although still preferable to GICs) than they were before.
While the premise of the strategy is getting a hit on both fronts in 2017, it’s still an excellent way for corporation owners to shelter their investments from tax. And even though the tax changes generally make logical sense, anyone who is fortunate enough to implement this strategy before the end of the 2016 calendar year can still save taxes based on the old life expectancy rates.
If you’re a business owner looking for some advanced estate planning maneuvers that pair well with your conservative nature, or for more information on corporate planning strategies, speak to a Certified Financial Planner today.
Written by Meagan S. Balaneski, CFP, R.F.P.
Meagan S. Balaneski, CFP, R.F.P CERTIFIED FINANCIAL PLANNER® Advantage Insurance & Investment Advisors Investment Funds Representative Manulife Securities Investment Services Inc.
The opinions expressed are those of Meagan S. Balaneski and may not necessarily reflect the views of Manulife Securities Investment Services Inc.