How life insurance can make for more tax-efficient intergenerational wealth transfers

Many people view life insurance mainly as a necessary cost during their working years – a safety net that, hopefully, won’t be needed. Yet, life insurance can play a key role in maximizing an estate’s value and allow wealth to move to beneficiaries quickly and without incurring taxation.

That can add to smart estate planning, whether between spouses or generations, says Kathryn Del Greco, senior investment advisor with Del Greco Wealth Management at TD Wealth Private Investment Advice in Toronto.

Clients often overlook the power of life insurance in passing assets along, as beneficiaries can skip over the time-consuming and fee-entwined probate period in which the will is executed, she notes. “Once you have a named beneficiary, it will bypass the will process and the associated costs.”

Advisors can add value to their relationships with clients and their heirs by using insurance strategies to keep wealth in a family. That has become even more important considering the recent hike to the capital gains inclusion rate. The move has refocused attention on efficient means to limit tax obligations on major transactions, including wealth transfers as part of estates.

“Tax-free cash is much more valuable now,” Ms. Del Greco says.

Life insurance can facilitate the transfer of real assets

A primary use case for a life insurance policy is to cover the tax bill created by the transfer of real assets, such as a family cottage. Typically, heirs look to inherited financial investments to cover the tax bill, which are subject to capital gains and income tax and are also at the mercy of market volatility.

“It may not be timely to be liquidating a portfolio to offset that expense,” Ms. Del Greco says.

In contrast, a life insurance benefit is a new injection of capital into the estate.

There’s also a time factor. Insurance policies are typically paid out within a couple of weeks of providing proof of death. That’s far quicker than typical timelines for accessing other inherited assets. Depending on what province clients are in and the complexity of the estate, the probate process can take six months to two years.

“To have an immediate source of liquidity paid into a beneficiary’s hands is extremely advantageous,” Ms. Del Greco says.

The value of life insurance for entrepreneurs

For professionals with their own corporations, such as doctors and dentists, an insurance policy held inside the company is among the most effective ways to transfer wealth, says Michael Pate, senior advisor and portfolio manager with Baun & Pate Investment Group at Wellington-Altus Private Wealth Inc. in Calgary.

“That’s what our main purposes for insurance has always been: getting trapped capital out of a client’s company,” he says.

Establishing an insurance policy paid for by the corporation can channel what would otherwise be taxable earnings into a tax-free vehicle. Beneficiaries can then access the assets through the corporation’s capital dividend account.

The tax implications for corporations are even more significant as they don’t benefit from the exemption of the new, higher inclusion rate of 66.7 per cent on the first $250,000 in capital gains that individuals do. (Individuals still have an inclusion rate of 50 per cent on the first $250,000 in capital gains earned in any given year.)

Mr. Pate says life insurance has become an important component of a diversification strategy, with a portion of a portfolio growing inside a permanent life insurance policy, which combines a death benefit with a savings component.

“It’s something you’re not likely going to pull money out of, so if you’re a high-net-worth individual passing that money down, insurance is very much worth it,” he says.

There are hurdles to consider, such as the up-front expense of the policy.

“The cost of permanent life insurance is significantly higher than term insurance. So, education needs to happen [about the benefits],” Ms. Del Greco says. “You’re creating a new asset class for the investor. It’s about shifting the conversation to that understanding. They’re not just paying for something and money’s going out the door. They’re creating a new bucket within their wealth for the next generation or estate.”

Getting policies in place early can be beneficial

Another obstacle can be qualifying for a policy. The later a client waits, the higher the premiums. For estate planning and overall financial planning, “it’s important for people to plan while they can, so they’re not exposed to uninsurable threats,” says Andy Kovacs, financial planner with Moments of Truth Insurance Services Corp. at Sun Life Financial Distributors (Canada) Inc. in Markham, Ont.

“We all walk a line of insurability,” he says. “The pandemic showed us that on a broad scale. One day we’re healthy, living our lives. The next, through no fault of our own, COVID-19 strikes.”

The sooner that conversation happens, the sooner clients can maximize the benefits insurance can provide in the estate-planning process, Ms. Del Greco says.

“Without exception, clients are gobsmacked at that final tax bill. And that’s a burden to the beneficiaries,” she notes. “For most clients, if we can show them a vehicle to offset that and to help reduce that burden, they’re very open to hearing about it.”