Insurance Changes for 2017 – Introduction to the Changes
Let us break down why you should buy whole life insurance before the changes in 2017.
Life insurance policies are classified as either “exempt” or “non-exempt”, which refers to its tax treatment. “Exempt” policies do not have the underlying investment income taxed on an annual basis as it occurs, nor is the death benefit taxed.
Obviously “exempt” status is desired since accrual taxation will occur as earnings occur. With very few exceptions all Canadian-written life insurance contracts are “exempt”.
However, the 2012 Federal Budget contemplated changes to the determination of exempt status for insurance policies. Eventually the legislation pertaining to insurance changes was ultimately passed at the end of 2014.
The changes were, for the most part, a tightening or closing of the loop-hole to shelter vast amounts of income through the use of life insurance.
Starting on January 1, 2017 the size of the allowable payments and, therefore, the payouts and cash values will be more limited for “exempt” policies. In short, once the rules are fully understood, and professionals and investors determine how to best utilize them, the powers-that-be decide to change the rules!
The good news is that policies that exist prior to January 1, 2017 will be subject to the current rules and not the new ones. This should be sufficient incentive to motivate investors to act. Should they fail to act, some could lose significant tax advantages that cannot be recovered.
What you need to Know
Corporately owned life insurance is a tremendous vehicle to allow business owners (i.e. shareholders) to plan for retirement and protect their heirs from the financial loss should they pass away.
Keeping the distributions from insurance tax-free requires that the policy be continuously “exempt”, and all insurers will guarantee that their “exempt” policies remain “exempt”. Presumably, if they fail to keep the policy “exempt” they will ultimately pay for any additional tax incurred by the policyholder and/or beneficiaries.
The details can be complicated, but to remain “exempt” a policy must pass the following tests:
- Pre-test – the terms and conditions of the policy haven’t changed materially since last year
- Annual Test – the annual growth of the death benefit is limited to 8%
- 250% Test– this prevents large “dump-ins” of capital to prevent the rapid rise of the death benefit over a rolling 3-year period, after the seventh anniversary has been reached
- Additional out-sized deposits should occur by this anniversary in order to lengthen the time-frame that it will grow under and to raise the capital prior to any scrutiny for this test
A Canadian private corporation with a Capital Dividend Account (CDA) can pay capital dividends to shareholders. The distinction is that these are flows of capital, not income, and as such are not subject to income tax. Withdrawals and payouts from insurance can be considered to be capital and distributed as capital dividends.
This is based on the fact that since the premiums paid into the policy are capital, they generally cannot be used as a business expense. This will reduce the cashflow of the business and not provide a resulting business expense to reduce taxable profits. The corporation’s account will provide guidance on the effects for taxation, cashflow, and operating capital to aid the decision to invest in a corporately owned insurance policy. And generally life insurance premiums paid by a corporation on behalf of an employee as part of the compensation scheme can be deducted as a business expense, but will make those premiums paid a taxable benefit in the hands of the employee.
There are additional rules for non-residents, setting up secondary corporations as the beneficiary, etc., so the bringing together of experts is vital.
Additional benefit, beyond the tax savings, can be derived by the beneficiaries on the death benefit. Depending on the insureds health, history and age, the premiums paid into the policy could generate a benefit that far exceeds investment earnings through the insurance death benefit.
Without complicating this introductory article, the insurance benefit would be the equivalent of approximately 12-15% annual yield.
The Bottom Line
Drive insurance decisions in 2016 to allow you to take advantage of the current rules.