Life Insurance Tax Shelter (ITS): Charitable Gifting of Insurance
In the investment world there can be tax consequences. These tax consequences can simply be stated in three steps. One, your company earns revenue and pays corporate taxes to the Canadian Revenue Agency (CRA). Two, you pay yourself income and then pay personal taxes to the CRA. Three, you take advantage of investment opportunities and then once again pay taxes on the investment growth to the CRA. Conclusion, you have just paid the CRA taxes three times. What if you are able to reduce paying taxes in step two significantly and possibly eliminate step three. One approach is an Insurance Tax Shelter (ITS).
An ITS is an insurance plan issued by a life insurance company that allows the insured individual to deposit an unlimited amount of money into the plan and shelter all the growth of the deposit investment from income tax.
The CRA allows insurance companies to issue these plans/strategies and maintain a tax shelter status only if the plan follows certain conditions. One, the insurance company has to keep a minimum amount of insurance coverage for each plan in order to keep it tax free. Two, the insurance plan should be a low cost decreasing coverage, but only enough to keep the plan tax free. The amounts of coverage are formulary rated by the CRA and must meet an annual test.
The ITS plans are designed to work like this. The earnings growth are tax exempt as long as they remain in the plan and the yearly expenditures on the plan are less than the tax that would have been paid on similar investment earnings such as mutual funds, bonds, etc.
For example, investing outside an ITS, let’s assume the average rate of return is 10% per year. A couple with a combined income and in a 50% income tax bracket would have to pay approximately $43,000 in taxes to the CRA on the earnings growth of their investment of $10k for ten years.
Investments protected within an ITS plan and assuming the same strategy, the couple invest $10k per year for ten years within the insurance tax shelter account with a 10 % rate of return. The couple would pay approximately $10,700 to the insurance company for the cost of the ITS plan for the ten years. The couple have just saved $32,300 in tax savings.
There are a variety of insurance tax shelter plans to choose from that provide flexible advantages such as, they allow the insured investor to vary the amount of cash they deposit into the plan, plus the insured can choose which investments to invest in.
When it’s time for the insured to withdrawal the investment growth as income, the insured has three ways of withdrawing tax free. One, the insured investor can make withdrawals from the tax deferred account and receive part of their income tax exempt. Two, they can leverage their account with a bank. The bank will use the insured’s ITS plan as security on the loan. This allows the insured investor to make a single loan or a series of loans as income.
The bank will capitalize on the interest so the insured never has to make a loan payment and the ITS will payout the loan upon the death of the insured investor. Plus, any insurance coverage leftover after the loan is satisfied will be paid out tax free to the beneficiaries. The benefit is that the loans are tax free plus the insured’s income is also tax free.
Three, for a non resident, when the insured withdrawals income from the ITS they simply can take out all the funds tax free. Currently insurance tax shelter plans are exempt from withholding taxes unlike RRSP’s withdrawals which are subject to the bank withholding 25% of the RRSP value and submitting to the CRA. Therefore 100% of the insurance value would be transferred to the insured within days of the insurance company being directed to do so.
Accountants, financial planners/advisors and of course insurance agents highly recommend ITS’s because they are an excellent way of building assets for retirement and then borrowing tax free income which maximizes spendable income, avoiding the withholding allowances, and possibly reducing or avoiding tax payable.
Charitable Gifting of Life Insurance
Another tax strategy for the insured is charitable giving through life insurance. There are two ways of a donor can gift an insurance policy. One, the donor can gift ownership of an existing life insurance policy to a charity and two, a charity can take out a life insurance policy on the donor’s life. Whichever way the donor chooses to structure the gift, the charity is the owner of the policy.
If the donor chooses to donate an existing policy, the cash surrender value of the policy less any outstanding loans on the policy or interest will be treated as the fair market value (FMV) of the policy. The advantage is that the FMV will be the value of the donation tax receipt issued by the charity. Secondly, the monthly premium payments on the policy paid by the donor, owned by the charity, will be considered charitable donations and the charity will issue tax receipts annually for the premiums paid.
Another strategy is for the donor to take out a new life insurance policy and name the charity as the beneficiary. When the donor dies, the charity will receive the death benefits. The disadvantage to this approach is that the donor won’t receive donation receipts for the premium payments made by the donor. This method doesn’t provide gift tax implications. The proceeds from the policy will be included in the donor’s taxable estate. However, the donor will receive an offsetting estate charitable deduction.
Either life insurance charitable giving option does have beneficial tax implications. The best option just depends on the donor’s tax strategy and current position with life insurance. The best advice is for the donor to ask their attorney or tax specialist to help them decide on the best approach.
By Bruce Allen, BBA BEc
