Insurance Planning Ideas
The basic purpose of life insurance is to provide financial support or compensation for your loved ones, in the event of your death.
Over the years, many variations on insurance-based themes have been generated, and indeed these have spawned a huge world-wide industry.
Making insurance affordable, while still creating a profit incentive for insurance providers, has resulted in a huge variety of insurance-based products and plans.
Herein we describe a few insurance-based ideas that we have encountered. Obviously, any specific situation would be based on the degree of insurance required, and, of course, the age and health of the party or parties to be insured.
Insurance to replace capital for charitable bequest
Older persons with substantial estates, particularly given the real estate and stock market booms of the past few decades, may be inclined to make substantial charitable gifts late in life, or upon their death.
Insurance can be used to accomplish that goal without significantly reducing the dollar value of the estate that will go to the deceased’s children or other heirs.
It often surprises us how relatively inexpensive an insurance policy can be for a “healthy” older person (insurance underwriters appreciate that death is inevitable - however, statistically a non-smoker without any serious diagnosed illnesses who has reached, say, the low 70’s, has a reasonably predictable remaining life expectancy. Actuaries spend their days figuring out these sorts of probabilities. The prices for insurance coverage for such people can be surprisingly low - for example, perhaps a single lump-sum premium of $20,000 would buy (without any further outlay) an insurance policy that might pay out $100,000 on death.
With these figures, individuals can anticipate substantial gifts to charities on their demise, and yet still keep their estate “intact” for their children.
Additionally, the tax credits which charitable bequests generate (currently, approximately 44% of the value of the bequest) can cover much of, or perhaps all, of the taxes arising on the death of the individual. These taxes vary, based on the extent and nature of the assets - cash and principal residences are not taxable in Canada, for instance. RRIF and other retirement deposits, unrealized stock gains, investments in private companies, gains on other non-principal residence real estate, and investments in U.S.-situs assets for non-residents of the U.S. are the major causes of significant estate tax liabilities for Canadians.
Insurance to access tax benefit of charitable bequest while still living
Insurance companies also offer income products, such as life annuities, which have special tax characteristics. Only life insurance companies can offer these products, due to the risks involved with the length of a person’s life - the longer a person lives, the more the insurance company pays out. But, on average, across the population, that risk is counterbalanced by people continuing to pay life insurance premiums. The actuaries who work for life insurance companies make sure these two opposing factors keep insurance companies solvent!
Older persons who are dependent on their retirement savings often wish to “lock in” their rates of return. Annuities can do this, and at the same time provide a tax advantage. For example, a fairly high portion of an annual annuity sold to a middle aged person would be taxable. However, an annuity for an 80-year-old would be mostly tax-free.
Retired persons who are drawing on tax-deferred retirement accounts, such as Registered Retirement Income Funds (or RRIFs), may have a relatively high tax bill to pay, as every dollar extracted from these plans represents taxable income. By the same token, the taxes likely to arise on their death may be a relatively low percentage of their total estate value.
If that person wishes to make a substantial charitable gift, they might choose to consider a combination of the purchase of a retirement annuity with the purchase of an insurance policy.
The cash that would other generate interest income would instead be invested in the annuity. In all likelihood, the annual tax generated by the annuity would be much lower than the previous situation. The insurance policy, on the other hand, would be gifted to a charity of the person’s choosing. Under Canadian tax law, the annual premium payable on such a policy is considered a charitable donation, and generates tax credits at the 44% rate. This usually means that the person can actually utilize the charitable tax credits in annual “pieces” to reduce the annual tax burden.
Contrast this to a the fairly common situation in which large charitable bequests made in the year of death result in “surplus” tax credits that cannot be used in either the year of death, or the prior year due to the relatively low estate tax bill.
Note that, under a plan in which a life insurance policy is gifted to a charity, upon death and payout of the insurance to the charity, at that time there is no donation, since the premiums paid prior to that time comprised the donation by the individual. Also, at the time of death, the monies paid out by the life insurance company would be the legal property of the charity, not of the deceased.
However, the point to be made, and to be discussed with your insurance agent, is that the amount of insurance payout that the charity will receive can often be much, much larger than what was intended in the first place. The donation is, thus, “magnified” to the benefit of all parties in the transaction.
The “10-8” investment plan
This plan of insurance is attractive to owners of successful businesses who wish to establish insurance coverage for estate planning purposes (often, in substantial amount, due to the large values built up in their private companies, thus generating latent estate tax liabilities).
At the same time, they do not wish to tie up significant cash resources in life insurance policies.
The insurance industry has developed what is generally termed the “10-8” plan to deal with such situations, and they have been very popular.
The essence of the plan is that the large annual life insurance premiums required for such coverage are deposited into a “universal life” type of policy. Immediately thereafter, a large portion of this deposit is borrowed back - perhaps 80% to 90% of that deposit.
Arrangements are made in advance for this credit facility - some insurance companies arrange for financial institutions, such as a bank, to make the loan. The interest rate on these loans is set at 10% (high, as this rate is guaranteed for life). By the same token, the investment fund on deposit in the universal life insurance policy is earning income at a guaranteed 8% rate.
The tax advantage arises because the 8% interest earned is not taxable within the policy, while the 10% interest paid on the bank loan is deductible, if the money was used for a deductible purpose (most business owners invest the lent money back into their businesses, which is usually the place where the premiums were originally paid from - and this is generally deductible).
Effectively, you have money working in two places at once: within the private company or investment portfolio, and also within the tax-exempt life insurance policy. The net effect is that you pay a deductible interest expense on the loan balance, and receive a tax-sheltered 8% credit on a like amount.
This type of plan carries risks, however. There is some debate in the insurance community concerning the “permanence” of the 10% loan. Also, “policy loans” are subject to strict rules regarding the adjusted cost base of the policy - if loans exceed this, taxable income results. Loans arranged from a supposedly third-party financial institution purport to avoid this rule, but some members of the insurance community doubt this. The calculation of “adjusted cost base” of life insurance policies is a complex exercise - and depends on actuarial input.
Readers are advised to proceed only after thorough consideration of the risk factors.