Creative Uses of Life Insurance for Estate Planning

Estate planning is simply not complete without considering life insurance.

Why?

In comparison to investing your own cash of $10,287 each year over your remaining life expectancy yielding sufficient cash on death to pay $1 million of estate taxes, you will need to earn, before taxes, 10.7% annually in order to be in the same position as a $1 million term 100 life insurance policy owner.1

If one also added the tax benefit of your company owning, receiving and paying to your estate the tax-free death benefit on your $1 million life insurance policy, the investment in annual premiums is equivalent to earning, before taxes, 19.2% annually.2

How Is This Possible?

Insurance companies are able to keep their insurance premiums down because 80% of insurance policies lapse. In other words, insurance companies receive premiums on 80% of their policies and do not have to pay out any death benefits resulting in pure profits.

As well, people are living longer and paying insurance premiums longer.

Finally, the tax man does not levy any income taxes on mortality gains, or on the income earned on the investment portion of universal life insurance contracts.

One Creative Use - Leveraging Life Insurance Cash Surrender Values ("CSV")3

Tax Deductible Interest

A Universal life policy allows for extra investment deposits into the life insurance policy that accumulate on a tax-deferred basis and form the policy’s CSV. These annual excess investment deposits can be made by your company if the company owns the policy.

Certain financial institutions will lend you personally 100% of the policy’s CSV owned by your company. The borrowings can be used to invest back into shares of your company creating tax deductible interest on your personal tax return. These interest tax deductions can offset taxable earnings received from your company by way of salary or dividends.

With this leveraged life insurance structure, the cash flow circle is complete - your company made the annual investment deposit to the policy followed shortly thereafter by a bank loan to you personally in the same amount, which is injected back into your company by way of equity investment.

Thus, your company has received back all of its initial cash outlay.

Example

For our leveraged life insurance CSV example, we will assume:

1. 10 year term, 9% interest on the personal bank loan secured by the CSV, and
2. 10 year term, guaranteed 7% rate-of-return on the excess investment deposits in CSV.

Positive Cash Flow

The positive cash flow can result if you can personally deduct the 9% personal bank loan interest each year (for an after-tax interest rate – 5.07%).4 At the same time, there is a guaranteed5 7% growth rate in the CSV against which you can draw a further investment loan.

The result is a net positive cash flow of 1.93% (7% - 5.07%).

After a few years, the tax benefit of personally deducting interest for tax purposes, while earning interest without tax inside the policy, will exceed the cost of the insurance premiums.

Therefore, once the personal loan and CSV are large enough, not only have your insurance premiums cost been reduced to NIL, there is a positive 1.93% cash flow.

Canada Revenue Agency ("CRA") Risks and Flexibility Leveraged Insurance Structure

Proper implementation and ongoing maintenance is a must to ensure tax deductible interest. For example, the 9% interest must be paid in full each year.

CRA could attempt to reduce the deductible portion of the 9% loan interest rate to a lower level that it believes is a reasonable rate, with a corresponding reduction in cash flow if CRA is successful. There are many persuasive arguments to support the reasonableness of the 9% rate set by the lender.

Tax legislation may also change.

Whatever the future may hold, and with changing circumstances, it is very important to choose a leveraged insurance structure that is flexible and easily unwound leaving you with the original insurance amount required to protect your family.

Ideal Client Profile

This type of insurance structure is suitable for individuals:

• Under age 70 who can handle a little risk and complexity;
• With business value greater than $10 million; and
• Earning taxable income greater than $1 million annually (personal and corporate combined).

How MNP Can Help

As your professional advisor, we can assist you in:

• Determining if a leveraged insurance plan is appropriate
• Choosing the insurance provider
• Reviewing the tax implications of the insurance structuring
• Advising on the appropriate level of insurance
• Putting in place a leveraged insurance plan

 
References

1Manulife quote dated January 25, 2011 assuming a 50 year old non-smoker male in the highest B.C. tax bracket earning interest measured over a 32 year life expectancy.
2Factors in;
i) an annual dividend tax saving of 33.71% due to premiums paid at the corporate level rather than personally.
ii) $337,100 tax benefit of the life insurance tax-free $1M mortality gain payout by the company.
3 There are other creative ways to leverage life insurance that are not discussed, such as leveraged insured annuities, charitable gift arrangements, and insured retirement plans.
4 Pre-tax loan rate 9.000%
B.C. Highest Personal Bracket
Tax Savings (43.7%) (3.933%)
After-Tax Loan Rate 5.067%
5 Financial institution guarantees 7% interest for same term as 9% loan interest