Life insurance can be a critical part of an estate plan. Yet, even clients who understand the role that life insurance plays in estate planning may not fully appreciate the nuances involved. This can put them at risk of liquidity challenges.
Joint last-to-die (JLTD) insurance policies are commonly used for married or common-law couples, since most assets have rollover provisions, and taxation may not be realized until the second death. While single life policies may address liquidity needs on first death, they can be an added cost, given that the premiums for a JLTD policy are calculated based on a “single equivalent age.”
For example, the premiums for a JLTD policy on two 50-year-old spouses may be equal to the premium for a 38-year-old, which translates to significant cost savings compared to a single life policy. The calculation of this single equivalent age can vary by type of insurance (e.g., universal life, whole life, T100) and type of cost, such as level or yearly renewable term cost of insurance on universal life.
If one of the insureds has passed away, the surviving spouse’s situation changes from what was anticipated at issue, and they may need an immediate source of income. Many JLTD insurance products offer a tax-efficient means of accessing some of the policy values on the first death of the joint insureds. This feature may be known as “account or fund value at first death,” “special death benefit” or “early death benefit.”
In all cases, the benefit is generally the same: part or all of the policy’s fund or cash value may be accessible on the first death. From a tax perspective, the payment is treated as a death benefit (rather than a policy withdrawal), which avoids any disposition.
It’s important to review the policy contract to ensure you understand the rules and conditions attached to such benefits. For example, certain policies don’t allow clients to add this feature after the policy is issued to avoid anti-selective behaviour. Also, many carriers require that all lives must be insurable, and the feature cannot be added post-mortem.
Special death benefit and estate planning
Here are a few ways you can use this feature to help your clients:
- Income replacement. A premature death might mean less earned income for the family, so that special death benefit might help cover a short-term cash crunch or supplement a survivor’s pension income, as many registered pension plans are reduced on the first death to two-thirds. In addition, if the deceased had to draw down their savings to cover medical expenses, the special death benefit could replenish the lost capital.
- Charitable donations to the deceased’s favourite charity. The special death benefit might provide funds to make a charitable donation, providing recognition for the deceased and helping reduce taxes in the deceased’s terminal tax return.
- Accelerated inheritance to children. The insureds’ children may use the proceeds from the special death benefit to help cover post-secondary education costs or for a down payment on a home. It’s no secret that the cost of education and housing are prohibitively expensive. Even if the surviving spouse has other assets, liquidating those assets might result in penalties or a taxable disposition.
- Loan repayment. If a policy is leveraged, the special death benefit proceeds can be used to pay down part or all of the loan balance. This could be helpful in cases where the surviving spouse doesn’t want to carry on with a lending strategy. For example, they may want to sell the business or the income properties tied to the insurance policy and not requalify or renew the loan. Repayment may also address valuation issues for income tax and probate purposes, particularly if the policy is corporately owned but the leveraging was done personally. The cash value of the policy is an asset of the company, and the special death benefit reduces the cash value.
- Business succession. The corporation could use the proceeds to redeem or buy back some or all of the surviving spouse’s shares in the company. This could be helpful if the surviving spouse doesn’t want to control the business. If there’s an estate freeze in place, the surviving spouse can decide to redeem preferred shares earlier.
- Probate planning. Clients can name a beneficiary such as a child, spouse or corporation for the special death benefit proceeds. By having a named beneficiary, clients can avoid probate and create a level of privacy they wouldn’t have if the estate were named as the beneficiary. (Probate fees may not apply in Quebec.)
Let’s look at a universal life and whole life case study, as these products offer unique advantages and some differences. It’s important to review the wording of the special death benefit in the policy contract, as each carrier might have nuances or may not offer the benefit on all plan types or configurations.
Corporate universal life
A couple, both spouses age 55, is looking to deposit $100,000 annually for 10 years into a $2-million universal life policy with Face Plus and level cost of insurance, owned by their holding corporation. The policy is invested in a balanced portfolio projected at 4.5% (net of the management expense ratio). Fast forward to age 80, and one spouse suddenly passes away. The projected balances are as follows:
- account value = $1,556,972
- adjusted cost basis (ACB) = $754,847
The policy contract states that the fund value less 12 months of cost-of-insurance charges can be paid out as a special death benefit. In this example, $1,532,495 is paid to the corporation as a tax-free special death benefit. A capital dividend account (CDA) credit of $777,648 is created, and since this policy was issued under the G3 tax rules (i.e., taxation specific to policies issued in 2017 and beyond), the special death benefit payout reduces the ACB dollar for dollar. This is important to note, because G2 policies (taxation specific to policies issued prior to 2017) will not have a dollar-for-dollar reduction of the ACB. As such, the ACB decreases to –$777,648.
The company may have a few planning options, including paying additional premiums from retained earnings, which would increase the negative ACB to zero. Thus, when the second spouse dies, the full death benefit payout (sum insured + fund value) would be added to the company’s CDA balance. It is important to remind the surviving spouse that, since nearly all the fund value was paid out, they must resume paying at least the minimum premium within the following 12 months to prevent the base $2-million universal life coverage from lapsing.
Personal whole life
A couple, both spouses age 50, deposits $100,000 annually for 10 years into a guaranteed 10 pay whole life policy for an initial death benefit of $2.32 million plus paid-up additions.
The policy contract states that the additional payment balance can be paid out on first death, which is effectively the sum of the additional premiums beyond the base premium less the deposit load.
Now, let’s say one spouse unexpectedly passes away at 65. Approximately $371,000 could be paid out tax-free to the survivor. The policy is fully paid up, so no base premiums are needed to keep the policy in force. Assuming the survivor lives to normal life expectancy (age 90), there is an additional death benefit north of $4.53 million.
Product selection and planning
In the case studies above, both products provided a similar value proposition to the clients, but universal was more flexible than whole life. You must look at the case specifics to see which product works best for your clients. There could be scenarios where the special death benefit is not as important, or the couple doesn’t need as much on first death, or they need as much back as possible on first death. Picking the right product and configuration for your client is critical, as you can’t go back and change the product.
The special death benefit feature can help address unexpected cash flow constraints on JLTD policies at first death, and it might help address some hurdles preventing clients from funding an estate plan. It’s another example of how life insurance provides tax-efficient ways of accessing policy values to cover short- and long-term planning objectives.
Pierre Ghorbanian, MBA, CFP, TEP, is the advanced markets business development director with BMO Insurance.