Life insurance can be the least liked tool in a financial planner’s kit. And it is understandable. It can be expensive and in some cases it has been oversold. But when used judiciously it can protect your family and loved ones in the event of a sudden death. It can be used in estate planning to pay taxes, fund a trust, leave an inheritance or donate to charity. It is also a leading strategy for owner-managed Canadian Controlled Private Corporations to fund a buy out of a deceased shareholder’s interest, offset the economic loss of a key employee, and may assist in securing bank financing.
If you are considering purchasing term, permanent or universal insurance policies or even prescribed annuities, the new rules apply to policies issued after December 31, 2016. The legislation takes into account that people are living longer, and that interest, inflation and insurance products have changed significantly since the tax rules were originally enacted, back in 1982. And the changes are not insignificant. In most cases existing policies will be grandfathered under the existing rules with the exception of policies converted into other types of policies or where additional medical underwriting has been added to the policy after this date.
So what’s changing?
There are a number of technical tax changes that will affect a few key areas. The changes include an updated calculation of the benchmark insurance policy; revised prescribed assumptions when calculating the accumulating fund of the exempt insurance policy; updated mortality tables that take into account increased life expectancies; and changes in the calculation of the tax adjusted cost base of life insurance.
How will the new rules affect me?
A reduction in the maximum funding levels for permanent insurance policies after the first 10-15 years
One of the benefits of permanent life insurance is that there is a savings element inside the policy which grows exempt from taxes. For the income to remain exempt from taxes however, the savings element must not exceed the limits set by tax legislation, referred to as the Accumulating Fund (AF) in the Exempt Test Policy (ETP). The new rules change the ETP calculation, effectively reducing the long term tax exempt room after the first 10-15 years in comparison with current polices, and therefore reducing the amount of income that can be deferred in an exempt policy from Canadian tax. The impact of the changes will be more significant for certain types of insurance including ‘Level Cost of Insurance Universal Life Policies’, but this change will impact all permanent insurance policies issued after the effective date. The new rules will not only change the maximum funding levels but may increase the cost of certain insurance policies. It will be necessary to evaluate how it compares as an estate or investment strategy versus other tax sheltered investment alternatives.
Corporate owned Life Insurance Policies will take longer to be effective
Corporate Life Insurance is attractive in owner manager planning, because the insurance proceeds received by the corporation on the death of the insured less the adjusted cost base (ACB) of the policy can be added to the Capital Dividend Account (CDA) and paid out tax free. Dividends paid out of the CDA are received by the shareholder or shareholder’s beneficiary on a tax free basis. The updated mortality tables used in the revised calculations reflect the increased life expectancy of Canadians and result in higher ACB’s reducing the amount of tax free CDA available.
Individual shareholders transferring Insurance Policies to their Corporation may have a bigger taxable gain
A common owner-manager planning strategy involves transferring your personal life insurance policy to your private corporation. Under the old rules, the proceeds of disposition under the income tax act were equal to the cash surrender value of the policy, which in many cases had little to no value and therefore could be transferred in tax free. Under the new rules, the proceeds have been revised to take into account the fair market value of the consideration received, which in many cases results in a taxable capital gain on the disposition.
The taxable portion of income received from prescribed life annuities is increasing.
If you are considering purchasing a prescribed annuity, the new rules take into account the updated mortality tables which increase the taxable portion of the prescribed annuity, thereby increasing the total tax paid. You may want to talk to your advisor about purchasing an annuity before the new rules come into effect to maximize your after tax cash inflow.
Term conversions to permanent policies will result in a loss of grandfathered status under the new rules
If you have existing term insurance and are contemplating converting it to permanent coverage, take note that the grandfathering rules will not apply. Term Insurance Policies converted after January 1 will be covered under the new rules. If you are considering converting your policy, you may want to consider converting it ahead of January 1, 2017.
What are the next steps?
The rules around insurance are extremely complex but if you think you may be impacted by these changes or if would like to understand more, please speak with your advisor as there may still be time to make changes before the new rules come into effect in January.