Where is Life Insurance most often used?

As a valuable tool in estate planning, life insurance is the most effective way to create liquidity at time of death. This section will cover some of the popular strategies, which include:

  • Income Replacement
  • Funding capital gains tax liability
  • Enhanced intergenerational wealth transfer
  • Funding Shareholder Buy/Sell Agreements
  • Enhanced retirement income
  • Charitable giving

Income Replacement

Life insurance has been used for many years as a way to protect families against the loss of income that arises upon the death of the mother and/or father.

The death benefit proceeds can be used by the beneficiaries to invest, or to purchase an annuity. This will provide them with an income that will replace all or a portion of the income that was lost at time of death.

A typical question regarding life insurance is: "What is the amount of life insurance that I need to protect my family?"

The answer to this question will vary depending on each person's circumstances. Key factors include:

  • Do both parents work?
  • What are the respective incomes?
  • What amount of debt do you as a family have?
  • What other financial assets do you own that could be used to produce an income?
  • What amount of income do you want to create at time of death?
  • Is the need temporary or permanent (typically people think in terms of a greater need while their children are between ages 0 and 21)?
  • What amount of income will the death benefit produce?

The beneficiaries have the option to either invest the funds, purchase an annuity, or some combination of the two. In order to understand these strategies, it helps to look at an example of both:

Investing the Proceeds:

If a family receives a $1,000,000 death benefit from a life insurance policy they can use those funds to produce an income. They can either invest it and live off the interest and dividends or purchase an annuity. he family:

Comparison of after-tax income: Traditional GIC-type investment vs Annuity

Example - Traditional interest-bearing investment 

  $1,000,000 Invested
Rate of Return 3% 4% 5%
Gross Income $30,000 $40,000 $50,000
Amount Subject to Tax $30,000 $40,000 $50,000
Net Income after Tax $15,000 $20,000 $25,000

Assumed tax rate 50%. Actual after-tax income will depend on the individual's tax rate

 

If the $1,000,000 was used to purchase a life annuity on the surviving spouse, this would provide a guaranteed lifetime income. The following are examples of the gross annuity income and its taxable portion. Annuities are a combination of income and return on capital, and only a portion of the income is subject to tax.

Example - Life annuity of $1,000,000 

  MALE FEMALE
Age 40 50 55 40 50 55
Gross Annuity Income ($) 44,618 48,557 59,664 44,085 47,802 57,704
Taxable Portion of Annuity Income ($) 17,663 13,345 6,754 20,162 16,938 11,192
Net Annuity Income After Tax 35,786 41,884 56,287 34,004 39,333 52,108

Annuity values as of July 2014, with annuity income guaranteed for life, with a minimum guarantee for 10 years.

Assumed tax rate 50%. Actual after-tax income will depend on the individual's tax rate

Funding Capital Gains Tax Liability

Life insurance is the most tax-effective way to fund capital gains taxes that arise at time of death.

A capital gains estate tax liability will arise when a person owns shares or real estate (other than their principal residence) at time of death that have a value that exceeds their original cost base. In many cases, the desire is to transfer these shares or real estate to the next generation. At time of death, the tax liability on the capital gain is triggered as these shares are "deemed" to have been sold. The problem in most cases is that there is insufficient cash to pay the tax due.

Life insurance is the most effective way to pre-fund this known future liability. It is a source of liquid capital at the time of death.

Relative Costs to Fund Estate Tax Liability

Further, if the policy is owned by a privately-controlled company, all or a large portion of the tax-free life insurance death benefit will be credited to the Capital Dividend Account. This CDA credit can be used to help reduce the capital gains tax liability. 

Life insurance funding options should be explored as part of any estate freeze transaction. There are benefits of funding this liability with life insurance.  

Enhanced Intergenerational Wealth Transfer

Life insurance can be used as an effective alternative investment product. It provides multiple unique features which include tax-exempt earnings growth, a tax-free death benefit, and a capital dividend account credit if owned by a private company.

Typical investment options that are available for non-registered investments gained from the sale of a business, savings, cashing in stock options or an inheritance, are some combination of stocks/equities, bonds, real estate or other alternative investments. These investments can be made through mutual funds, investment counselors (segregated or pooled funds), hedge funds, or directly through a broker. If the goal is to eventually pass some or all of this investment pool to the next generation, as opposed to spending it during one's lifetime, then a life insurance policy should be considered as an additional investment option.

A Whole Life insurance policy, with its tax-exempt investment capability, provides an excellent internal rate of return and alternative to a taxable fixed-income portfolio. As such, it should be included as part of a diversified portfolio.

Many people use a life insurance policy as an alternative investment tool. This strategy is used even when they do not have a traditional need for life insurance, such as for income replacement. 

Funding Shareholder Buy/Sell Agreements

Partners in a business will typically enter into a shareholders agreement. This agreement is an attempt to deal with various situations that may arise between the shareholders. A common issue is what will happen in the event of the death of a shareholder. Usually there is a buy/sell provision, which states that the surviving shareholders will buy the shares of the deceased shareholder and the estate of the deceased shareholder will sell those shares.

As such, there is a financial obligation that arises as a result of death, and life insurance is the best way to plan for this obligation.  

Enhanced Retirement Income

If someone obtains a cash value policy when they are in their 30's or 40's to provide, for example, income replacement needs, they can then use this policy when they are in their 60's or 70's to provide for an enhanced retirement income. This can be done by borrowing against the cash value in the policy and having the death benefit pay off the loan.

In order to understand this strategy, consider this example:

A 40 year old male purchases a cash value permanent policy (Whole Life or Universal Life) with premiums payable over 20 years. At age 70, he will have accumulated significant cash value in the policy. He can then use the cash value in the policy as collateral to take out a loan. The loan proceeds can be used by the insured for whatever purposes he wishes, including living expenses during his retirement. The interest on the loan can then be capitalized. Meanwhile, the cash value and death benefit in the policy will continue to accumulate tax exempt. Then, when the person dies, the death benefit can be used to pay off the loan, and any remaining money can go to the beneficiaries.

Charitable Giving with Life Insurance

There are a variety of charitable giving strategies using life insurance, many of which involve complex planning. Some of the more basic strategies are:

  • Apply for and put into force a policy and then transfer that policy to the charity of choice. Each year, the insured will donate the amount required to fund the policy and receive a charitable receipt for that amount. The charity will use these funds to pay the cost of insurance.
  • Donate an in-force policy with or without cash value and receive a donation credit based on the fair market value of the policy at time of donation.
  • Donate a lump sum to the charity equal to the amount needed to fund a single-premium life insurance policy.
  • Direct in your will that the death benefit proceeds from a policy paid to the estate, be used as a donation, thereby creating a donation tax credit available to offset other estate tax liabilities.