Change to life insurance tax coming

Life insurance, along with one’s principal residence, Registered Retirement Savings Plans and Tax-Free Savings Accounts, have long played critical roles in supporting the financial health of Canadians.

However, the taxation of life insurance is about to change.

This means any additions or changes you make to your life insurance plans after Jan. 1, 2017, might become less beneficial than if they were made today.

The good news is that you have almost six months left to put life insurance policies in place that can be grandfathered into the new tax regime and provide a more advantageous tax treatment.

The existing rules for the taxation of life insurance policies allow for investment earnings associated with the cash value of policies to accumulate tax free. The maximum amount allowed to accumulate is referred to as the “exempt test” policy.

The government believed that these rules were too generous and needed to be modernized to reflect recent changes to mortality tables.

Generally speaking, the new rules will affect the following:

  • The amount allowed to accumulate tax-free will be reduced.
  • The removal of surrender charges from the calculation will standardize the calculation and reduce the tax-sheltered amount allowed to accumulate within the policy.
  • The use of more recent mortality tables that reflect that Canadians are living longer will reduce the net cost of pure insurance and therefore increase the adjusted cost basis of the policy.

As well, after the compulsory collapse of your RRSP in the year you reach 71, more of the income from the annuity will be taxable, making the net yield of the investment less favourable.

These changes might not seem extensive, but they will significantly affect the ability of a policy to shelter investment money from taxation.

This can represent as much as a 70 percent reduction in accumulation room after 20 years. The new rules will produce lower savings at an increased cost.

For corporately held policies, a lower net cost of pure insurance results in a higher adjusted cost basis and thus a lower credit to the corporation’s capital dividend account upon death.

Canada Revenue has also introduced measures that effectively eliminates the following two important strategies used by business owners:

  • A holding company owns the policy while an operating company is the beneficiary. This strategy allowed the operating company to maximize the capital dividend account regardless of the adjusted cost basis of the policy.
  • The policy is transferred from shareholder to a corporation in cases where the fair market value was determined by an actuary. This was usually done when policy owners were of advanced age, in poor health or had decreased life expectancy.

With the changes these strategies are no longer useful.

Now is the time to look into these strategies if you’re thinking of using insurance to generate additional retirement income or increase tax-free capital dividends through your capital dividend account within corporations.

Contact a financial or estate planner if you have any questions about these changes.

Grant Diamond is a tax analyst in Saskatoon, SK., with FBC, a company that specializes in farm tax. Contact: fbc@fbc.ca or 800-265-1002.

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