How to keep your estate intact

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How to Keep Your Estate Intact

Many people assume their life insurance needs decrease as they become more successful financially. They believe that their dependents can survive on their accumulated wealth, so life insurance is no longer necessary. While this is true to a certain extent, other life insurance needs will arise as their net worth increases.

Some people have built up a significant amount of wealth over their lifetime. They’ve worked hard and have put their blood, sweat and tears into accumulating their assets. What is most important to them, after they have achieved their retirement goals, is to keep their estate intact for the next generation. In Canada, the biggest impediment to this is taxes. There are several options available to Canadians for funding this tax liability. Which method is the best?

Current and future taxes on death

In Canada, the spousal rollover allows a deceased spouse to pass his assets on to his spouse on a tax-free basis. Therefore, there usually is a minimal amount of tax owing on the first death of a couple. The tax burden is deferred until the surviving spouse also passes away. At this point, all the property under the surviving spouse’s name is deemed to have disposed at the fair market value, triggering a capital gain. With depreciable property, there can also be a recapture of capital cost allowance in addition to the capital gain.

Assets that may have accumulated a large capital gain include investments such as stocks, bonds and mutual funds, the family cottage and shares of a small business. The family home is not included in the calculation because under the principal residence exemption, the capital gain on a family home is exempt from taxes.

The taxable amount that must be included on the final tax return is half of the capital gain. In addition to capital gain, the fair market value of the RRSP or RRIF is also taxable on the surviving spouse’s death, provided there is no qualified beneficiary.

With all of these assets being taxed at the same time, the marginal tax rate will be increased, resulting in an even more significant tax liability. Even with strategies such as charitable giving to reduce taxes, there is only so much tax planning you can do to minimize your tax bill. Eventually, the government will receive its portion, which can be almost half the value of your assets, depending on your marginal tax rate and the province in which you reside. Therefore, your estate planning goal does not only include tax minimization, but also encompasses estate preservation. The idea is to provide funding for the tax liability so that the estate is kept intact for the next generation.

Methods of keeping your estate intact

If you do not plan for your future tax obligation, here are several options your heirs can choose to pay off the tax bill. They can liquidate some of your assets after you pass to generate enough cash. This is not ideal because during a market downturn, assets may be sold at a loss. Also, assets such as cottages take a long time to find a buyer.

The second thing they can do is to borrow from a bank to pay off the taxes. It’s unsure if existing debt or a poor credit rating will affect their ability to obtain a loan. Even if they have no trouble getting a loan, there will be interest charges on it.

Finally, they can save now and hope that they have enough to cover the tax liability. Many factors will affect their ability to build up a sufficient portfolio, including their income, risk tolerance and time horizon. Depending on the size of your estate, this could be an unreasonable expectation.

Which of these methods would your heirs prefer? Even if they are capable of applying these options, is this what you intended? Each of these options will be a cost to your heirs. Wouldn’t you rather plan ahead and relieve them of this burden?

Permanent life insurance for estate preservation

A more efficient method of funding the tax liability is to use permanent life insurance. With a joint last-to-die policy, the death benefit will be available upon the death of the last surviving spouse. It matches the tax obligation that will be triggered on the death of the surviving spouse. Because a joint last-to-die policy only pays once, it is much more cost efficient than owning two separate individual policies on each spouse. The estate of the survivor should be named the beneficiary of the policy to provide liquidity necessary to pay for the tax bill.

As your assets will likely rise as time goes on, so too will the accumulated capital gain and your tax bill. What may be sufficient to cover the tax liability today may not be enough down the road, which is why a specific type of permanent life insurance with an increasing death benefit is necessary. The two types of permanent life insurance with an increasing death benefit are participating whole life insurance and universal life (UL) insurance.

With a participating policy, dividends paid into the policy can be used to purchase additional insurance. Dividends are also paid on the additional insurance, providing a compounding effect that increases the death benefit at a rapid rate. Although dividends are not guaranteed, most providers of participating whole life policies have been able to distribute a dividend every year since the beginning of its existence. Participating whole life is a more hands-off product, with the investment decision in the hands of the insurance company.

A UL policy provides more flexibility by allowing you a choice from a suite of investments, from conservative to aggressive. You can deposit as little as needed to keep the policy in force, or as much as the policy allows you to accumulate investments on a tax exempt basis. The account value will be added to the base death benefit and the total will be paid out on a claim.

Perhaps the biggest benefit to either of these two policies is the ability for investments to grow tax-sheltered. Legislation allows investments within permanent life insurance policies to grow without any tax consequences, as long as it remains under the maximum tax-exempt amount. At death, the entire face amount, which is composed of the base death benefit and investment, is paid to the beneficiary tax-free.

Don’t assume life insurance needs decrease as you become more successful financially, since your tax liability also increases. With increasing death benefit life insurance, the death benefit will be available to fund the tax obligation, allowing you to transfer the maximum value of your net worth to your beneficiaries. For more information on which life insurance policy is suitable for you to keep your estate intact, contact an insurance advisor.

Image courtesy of Ken_Mayer / Flickr / Photo under public license