Keep insurance returns tax-free

When clients buy insurance, the Income Tax Act classifies policies as meant for protection, not investment.

So investment earnings are not taxable—an attractive selling point. But after a policy’s 10th year, it must pass three tests to remain classified as for protection, known collectively as the Exempt Test.

The recent budget indicates the Department of Finance will look at revamping the tests to add some additional guidelines (see advisor.ca/exempttest). But old policies will likely be grandfathered under the existing rules, so it’s worth knowing what they are.

Read: Faceoff: Is costlier insurance cost-effective?

The Exempt Test is especially important to consider on two occasions: when converting a policy from term to permanent, or when suggesting a client deposit additional amounts into an existing permanent policy after its seventh year.

Here are the components of the Exempt Test:

Pre, and annual test: The law says an insurance company must test the policy when it’s issued, and then on every policy anniversary. It must not have an excess amount (based on the maximum tax accrual rules, or MTAR, limits) of contributions growing tax-free. This often happens when interest rates are high.

Insurers are contractually obliged to ensure a policy retains its tax-exempt status. To do that, they’re allowed to increase the face amount of the policy by as much as 8% each year to shelter the additional amount of cash—but will charge additional premiums for that increase.

If that still doesn’t do the trick, the insurer must refund excess investment contributions to the policy owner.

And if, when the insurer performs the test in the following year, the investment portion amount falls below the threshold, the insurer can reduce coverage. Your client’s premiums will fall accordingly.

Read: Can life insurance be held as an asset class?

You can indicate on the contract that you want this to happen automatically. But if your client is uninsurable past a certain threshold, allow increases (but not decreases) in the policy’s coverage—this can give her an 8% bump in coverage that she needs and couldn’t get any other way.

250% test: On the policy’s 10th anniversary, and every third year after, the insurer must perform an additional test. It’s called the anti-dump-in or 250% test, and it’s intended to restrict contributions larger than 250% of the policy’s accumulated value after the seventh policy anniversary.

This keeps clients from putting inordinate amounts of money into their policies to grow tax-free, which could happen if a client wins the lottery or experiences some other windfall.

It’s also important to consider the Exempt-Test rules when converting a term policy to a universal life plan. If a policy is converted after year seven, the 250% rule may significantly restrict the amount of deposits that can be made to the permanent policy.

Here’s how to ensure policies—Don’t risk failing:

• When determining coverage, factor in customary issues like age, health and income;
• Include how much the client wants to invest; and then
• Ensure coverage is sufficient to shelter those deposits tax-free (as well as provide protection).

Read: Goodbye retirement?

Example:

Sunil wants to deposit $120,000 per year into his insurance policy, or $10,000 per month. If the premium on a $1-million policy is $1,000 per month, he would deposit $11,000 per month for the first year. That deposit could change annually based on interest rates and investment returns.