When used strategically, life insurance can be a powerful tool beyond basic protection. Let’s explore how you can use a policy to optimize your tax outcomes and enhance estate plans.
In this guide, our editorial team reviewed the Financial Consumer Agency of Canada’s life-insurance guide, FSRA’s explanation of life-insurance policy types, the Canada Revenue Agency’s capital-dividend folio, and CRA’s policy on gifts of life-insurance policies.
How Can High-Net-Worth Canadians Use Life Insurance?
Limit the use of life insurance to situations where a death benefit need isn’t adequately addressed with liquid assets and primary tax planning, and there are no good alternatives. Common uses include estate liquidity, business succession planning, inheritance equalization and charitable giving.
Cash-value access can be considered when designing a policy, but it should not be pitched as a sure-fire retirement income source or an easy way to get a tax-free loan.
Remember, the illustration is just one factor in the equation. Ownership structure, beneficiaries, corporate tax situations, interest rates, loan conditions, charges, dividends, and timing of death or surrender all come into play.
Common Estate and Business Uses
Have the structure modelled by a tax adviser. Have a lawyer document the ownership, beneficiary, shareholder, and estate consequences.
High net worth alone doesn’t make a household or corporation appropriate. The right circumstances include dependable cash flow, a long time horizon, and access to professional advice.
1. Corporate-Owned Insurance for Estate and Business Liquidity
Life insurance owned by a private corporation, which can pay the premiums and receive the proceeds, can provide funds to redeem shares, repay loans, facilitate a business succession or pay taxes, depending on the wording of any agreements and the amount of insurance.
Remember that corporate dollars are not personal dollars. Life insurance in the hands of a corporation has creditor, estate, and shareholder implications. The life-insurance credit to the capital-dividend account (CDA) is based on the net insurance proceeds. Start with the proceeds, subtract the policy’s ACB just before death, and there may be further deductions. The corporation must be able to prove the CDA and elect to pay a capital dividend.
Read More: Read the Guide to Corporate-Owned Life Insurance
2. Borrowing Against Policy Value
| Question | Policy loan | Collateral bank loan |
|---|---|---|
| Who is the lender? | Insurer, subject to the terms of the policy | A bank or other lender under a separate credit agreement |
| What sets the rate? | The policy’s loan provisions | The lender’s credit terms, which may be variable |
| What can change? | Interest plus the balance due reduces the net value of the policy | Rate or margin, collateral, and renewal or repayment requirements |
| What happens at death? | Any outstanding loan at death reduces the proceeds paid | Allocation of the remaining proceeds is controlled by the loan and assignment documents |
| What must be modelled? | Loan balance, interest, policy lapse and tax advice | Loan amount, interest, cash calls, additional collateral, lender exit and CDA |
Remember that borrowing is NOT creating unencumbered liquidity.
You should model the higher-interest-rate case, lower-dividend case and pay-off case separately.
Understand what happens when the loan value exceeds policy-value growth. Who is responsible for posting additional collateral?
Read More: Read the Guide to Borrowing Against Life Insurance
3. Charitable Giving With Life Insurance
Many HNW individuals want to donate to a charity using their life insurance policy’s death benefit.
| Structure | Control during life | Tax and documentation question |
|---|---|---|
| Charity named as revocable beneficiary | The owner generally retains control and can change the designation | Confirm with your adviser the estate rules and when donation credits occur on death |
| Charity named as irrevocable beneficiary | Changes can usually be made with the beneficiary’s consent | Document the intended gift and provincial beneficiary rules |
| Policy absolutely assigned to a qualified donee | The charity becomes owner and irrevocable beneficiary | CRA considers this to be a gift other than cash, subject to the FMV and ACB rules for receipting purposes |
| Cash donated for premiums on a charity-owned policy | The charity controls the policy | Gift and advantage rules apply when issuing a tax receipt for a qualifying premium donation |
Contrary to popular belief, a policyholder who takes out a loan and donates that amount to charity is NOT taking advantage of a unique life-insurance tax break. Each part of the process needs to be considered independently: the cost of the loan, charitable tax rules, gift receipts and what happens with the policy.
4. Estate Equalization and Survivor Planning
One heir receives the family business or other property; the other receives cash to make up for it. It’s succession planning. The proceeds could also support a surviving spouse after the first-to-die’s passing.
Check beneficiary designations against the will, shareholder agreements, marriage or prenuptial agreements, trusts, and tax plans. Naming a spouse as the beneficiary of a life insurance policy doesn’t, by itself, meet all succession-planning and equalization requirements.
Read More: See How Life Insurance Can Transfer Wealth
Why Policy-Backed Borrowing Is Not Guaranteed Retirement Income
A retirement borrowing plan is NOT a pension. Such a plan depends upon the availability of a lender who will lend at rates and terms consistent with your plan, continued policy performance, and adequate collateral.
Universal-life policy values fluctuate with investment performance and policy charges. While a participating whole-life insurance policy has the potential to build cash value and earn dividends, dividends are NOT guaranteed.
Read More: See Whether a Life Insurance Retirement Plan Is Worth It
Stress-Test the Strategy Before Buying
Other risks include:
- The corporation not having enough cash flow to continue making the premium payments;
- Dividends or investment performance being less than illustrated;
- An increase in borrowing rates, which can lengthen the time in which interest charges accumulate;
- The lender requiring more collateral, reducing the percentage that can be borrowed against the policy or refusing to renew the line of credit;
- A change in tax legislation, CDA availability, shareholder circumstances or charitable intentions before receiving the proceeds;
- The insured outliving the timeframe illustrated; and
- The policy being assigned or cancelled.