Note: This is part one of a series on tax and insurance.
In 2016, 22 million Canadians owned $4.3 trillion in life insurance coverage, reveals the Canadian Life and Health Insurance Association. But owning coverage isn’t the same as being properly insured. It’s up to advisors to demonstrate how insurance can add value to their clients’ estate plans — and that means understanding the tax attributes and explaining them in a jargon-free manner.
Here’s what you need to know.
Permanent insurance and tax
From a tax perspective, life insurance is neither capital property nor debt instrument. It’s governed by a special set of rules in the Income Tax Act and accompanying regulations.
First, life insurance premiums, whether paid personally or by a corporation, are typically non-deductible, resulting in premiums being funded with after-tax dollars. On the other hand, life insurance death benefits are tax-free.
Permanent insurance, which provides lifetime coverage as long as premiums are paid, initially has higher premiums than term insurance. That’s because premiums not only cover the current mortality and other costs under the policy, but also fund a reserve to help pay future premiums. This policy reserve is invested by the insurance company, and, assuming the policy qualifies as an exempt policy, the reserve’s earnings accumulate on a tax-deferred basis, and can be used to offset future policy premiums and mortality costs as the client grows older.
Regulations set out rules for determining if a policy is exempt. Almost all permanent policies in Canada are exempt policies, and the insurance company is responsible for ensuring the policy complies with the rules. For example, there’s an upper limit on how much can be accumulated in the policy reserve, which in turn affects the permitted maximum annual premium.
It’s important to note the exempt test rules have been modified for insurance policies issued in 2017 or later years (as well as to policies issued before 2017 if certain changes are made). These changes generally put further restrictions on how much can be accumulated within an exempt policy. Despite these changes, the policy reserve can still grow significantly over time.
The tax-deferred reserve benefits the policyholder in several ways. First, as already mentioned, over time the reserve may be used to subsidize some or all future premiums and mortality costs. In this way, pre-tax dollars help pay for the policy. And for some policies, the cash surrender value (CSV) of the policy reserve at death can be added to the original insurance benefit, enhancing the tax-free death benefit.
As well, depending on the type of policy, the CSV of the policy reserve represents an asset of the policyholder. It may be withdrawn from the policy or borrowed against as a policy loan under the policy or as a secured loan from a financial institution.
However, if a policyholder attempts to access the CSV of the policy before death, there may be adverse tax consequences. For example, if a policy is surrendered, any CSV in excess of the policy’s adjusted cost basis (ACB) is taxable to the policyholder, and the gain is taxed like interest income (100% income inclusion) rather than a capital gain (50% income inclusion).
In future articles, we’ll discuss what types of transactions are treated as dispositions of a life insurance policy, how a policy’s ACB is determined and the relevance of the term “net cost of pure insurance.” Stay tuned.
Kevin Wark, LLB, CLU, TEP is managing partner, Integrated Estate Solutions, and tax consultant, Conference for Advanced Life Underwriting. He’s also the author of The Essential Canadian Guide to Estate Planning.