In Canada, income is taxed using a marginal tax rate system, where high income earners are taxed more heavily on each dollar they earn than a lower income earner. Tax planning strategies usually involve some kind of tax splitting with lower income earners of the family, such as a spouse or child under 18. The government restricts the benefits of income splitting with attribution rules, which are designed to attribute income back to the high income earner of the family.
For example, if you give your child money to invest, then the investment income will be attributed back to you. This means that you, and not your child, will report the income on your tax return. Note that only interest and dividends are attributable, meaning capital gains will be taxed in the child’s hands. Also, second generation income, which is income earned from the original income, is not attributable.
How are you supposed to efficiently transfer your wealth to your children, if income generated from their investments are attributed back to you? One of the ways to pass on your wealth is via a permanent life insurance policy.
Transferring wealth using life insurance
We typically think of life insurance as the transfer of wealth at death, but did you know that it can also be used to transfer wealth during life in a tax efficient manner?
You probably know from a previous post that investments within a permanent life insurance policy grow tax-sheltered, within a certain limit. The investment account within a permanent policy functions similar to an RRSP or TFSA, where returns can compound without being dragged behind by tax. The other thing to remember is that an insurance policy can be transferred on a tax-free rollover basis to a child, as long as the child is the life insured under the policy. With a tax-free rollover, tax can be deferred on a policy with a significant cash value.
Knowing these two traits of permanent life insurance, how do you design a policy to transfer wealth to the next generation?
The answer is to purchase a permanent policy, naming yourself as the owner and your child as the life insured. Two specific types of permanent insurance – participating whole life and universal life – allows you take full advantage of tax-sheltered investing by overfunding it. Overfunding means to deposit above the minimum required to keep the policy in force, so that the extra deposits are invested. Since returns in the form of interest, dividends and capital gains are sheltered from tax, the rules of attribution do not apply. A taxable event only occurs when there is a withdrawal or loan from the policy.
Another benefit is the insurability factor. By purchasing life insurance while they are young and health, you are locking in their insurability such that their coverage will be in place even if they become uninsurable in the future. Also, basing the life insured on a younger life means immediate savings in the form of lower premiums, allowing you to allocate more of the deposit into the investment account.
The cash value belongs to the policy owner, so you can use the cash within the policy however you like before you transfer it to your child. After the transfer, your child can either withdraw cash or take a loan from the policy. With either of these options, tax will be triggered if the amount withdrawn is greater than the adjusted cost base (ACB). In most cases, the ACB will start out small in the early years, peaks during adulthood and drops as the life insured enters retirement age. Therefore, withdrawals before retirement are less likely to attract tax.
There are several caveats that you should be aware of. First, attribution rules still apply if the child withdraws from the policy before the age of 18. Another complication that affects this wealth transfer strategy is the owner’s premature death. The child should be named the successor owner of the policy so that if the primary owner passes away, the policy bypasses the estate and is directly transferred to the child. This prevents a disposition of the policy, which would result in taxation on the final return.
Passing on your wealth to the next generation is an eventuality. Whether that happens early in life or at death depends on your financial and life goals. Whichever you choose, remember that the tax consequences of life insurance policies and wealth transfer strategies can be substantial, and shouldn’t be ignored.
Image courtesy of stockimages / FreeDigitalPhotos.net