Unless you sell insurance policies, chances are you have not given much thought to life insurance rules today. There is even less chance you have thought about how those rules fit with the Income Tax Act. Fair enough. Death and taxes may be inevitable but they are not things we obsess over. Even though it might be dull, big changes for the taxation of life insurance policies are on the horizon. Time is running out to lock in the old rules.
Life insurance is a good idea for many reasons, of course. Those advantages extend beyond merely providing for family after your death. The insurance industry has created many vehicles which can be attractive investment options during your lifetime.
The appeal of life insurance is driven by some advantages granted under the Income Tax Act. One is deductibility of premiums. Where life insurance is obtained as part of business operations, some or all of the premiums may be tax deductible. This brings the actual cost of the protection or investment down.
Another advantage is the taxation of insurance proceeds. Some or all of the payment on death might be paid tax free. Again, this increases the value of the funds substantially. Given these advantages, life insurance policies are a well-known and valuable tool for succession and corporate planning.
There are limits to good things, especially where taxes are concerned. The Department of Finance has long recognized the need to restrict deductibility and tax free payouts to prevent abuse. For instance, the Act has relied on concepts such as the Net Cost of Pure Insurance to restrict deductions. Still, the advantages of insurance can be significant.
Those advantages will be substantially scaled back with new Income Tax Act rules starting January 1, 2017. Although some changes may be neutral or even beneficial to taxpayers, the majority will not. The good news is that through grandfathering, insurance policies issued before the end of 2016 can still benefit from the old rules.
Here is an example, without getting too much into the weeds. Life insurance proceeds received by a corporation can qualify for a notional account called the Capital Dividend Account (CDA). CDA amounts can be paid to shareholders tax free, but the account is reduced by the Adjusted Cost Base of the policy. The ACB varies over time and tends to increase in the early years of a policy, then ultimately decreases to zero. The changes to the Act will substantially increase both the amount of the ACB and the time it takes to disappear. In other words, chances are the new rules will mean a lower CDA and therefore higher tax at a given time.
There are other changes which will reduce the after-tax return of insurance investments. There will still be benefits, but they might not be enough to warrant their use. This can affect the efficiency of succession planning in a business or for higher income earners.
Policies issued before 2017 will usually get to take advantage of the current rules. That is not the same as the date you apply for the policy. There will always be a delay between agreeing to buy the policy and the actual issuance, depending on medical exams or other administrative functions. Tack on the time it will take to actually figure out which policy is best and it might be several months before issuance.
Put another way, do not expect to be able to contact your insurance agent or broker on December 1 and have something in place by year end. The time to explore opportunities is disappearing fast.
Even if there are no immediate deductibility or investment requirements, at least consider creating a policy now so it can be grandfathered under the old rules. In a few years, if circumstances change, you will have a policy that can be used to shelter extra amounts that post-2017 contracts will not be able to provide.
On the other hand, there may some benefits to buying a policy after January 1, 2017 depending on circumstances. You should still determine this now so a comparison of before and after can take place.
The tax rules around insurance are eye-glazingly complex, even for experts in the field. We cannot go into all the changes here but they are not just theoretical. And they are not just for the super-rich. Most small business owners should check into the possibilities since there could be immediate and substantial financial benefits.