You may not need it to protect your family, but life insurance can help simplify estate planning
By Olev Edur
‘‘Why would I want to buy life insurance at my age?” one retiree asked during a recent seniors’ bridge session in Toronto when the subject arose during post-game conversation. “My kids are all grown up now, they have good careers, nice homes, families of their own. I don’t need to worry about them, and my wife and I have enough money not to worry about us. What would I do with life insurance?”
It’s a reasonable question on the face of it and, certainly in the case of many retirees, life insurance would seem to have little to offer in the later stages of life, especially given the increased cost of buying coverage that is based on age-related mortality statistics. Nevertheless, when it comes to planning one’s estate, life insurance can sometimes provide unique advantages over other types of financial products.
For one thing, the proceeds of a life-insurance policy are generally tax-free, unlike assets that are held in RRSPs or RRIFs, or the profits from the sale of second properties such as cottages. For another, life-insurance payouts can go directly to designated beneficiaries, bypassing the estate and the probate process. In provinces with high levels of probate fees, notably Ontario, British Columbia, and Nova Scotia, the ability to forego probate can translate into thousands of dollars in savings even for a relatively modest estate.
“Life insurance proceeds can go directly and immediately to the individuals you want,” says Steven Cooney, senior vice president and the head of Individual Life and Annuities at BMO Insurance in Toronto. “The benefits will be tax-free and they pass outside the estate, so they are not subject to probate fees.”
In addition, the amount forthcoming from a life-insurance policy is generally fixed and guaranteed, unlike, say, returns from investments in the stock market, or the proceeds from the sale of a cottage or a rental property. You know exactly what you (or your beneficiaries) are going to get when the time comes, and this can sometimes make planning much more straightforward.
As Nicco Bautista, the director of estate planning with BMO Private Wealth in Vancouver, points out, investment balances can go up and down over time. “This is not only because of market fluctuations, but also because with a RRIF, for example, you have mandatory withdrawals every year, so the balance changes. With life insurance, you know what the death benefit will be—it doesn’t change.”
Paying Off Taxes and Debts
So how do these features apply in formulating your estate plan? In what types of situations can life insurance be used most effectively?
“One of the primary uses of life insurance in estate planning would be to offset tax liabilities,” Cooney says. “Many people have cottages, for example. If you have one and want to keep it in the family, taxes can be a problem because upon death, the property will be deemed to have been sold, and it’ll be taxed accordingly. Life insurance can provide tax-free funds to offset that tax, so that the cottage—or any other taxable gift—can be passed on to heirs as desired, according to your will.”
The taxation of RRSPs or RRIFs can be an even bigger problem. Unless the plan can be rolled over into the hands of a spouse (or in certain cases, a disabled family member who has been dependent upon you), in which case the tax can be deferred, the full amount of a RRIF or RRSP must be added to your final year’s income and is taxed at your top marginal rate. When it comes to real estate, the capital gains that have accrued while you have owned it are taxed at only half the rate of regular income.
Life insurance can also be a valuable estate-planning tool in situations in which the estate is faced with sizable debt obligations. As with taxes, the ability to harness a tax- and probate-free source of immediate cash can solve many problems that otherwise might necessitate the sale of assets, perhaps at an unpropitious time. One example might be if you had to liquidate investments during a market downturn to pay off a mortgage balance.
While many people are able to eliminate all their debts—mortgages, car loans, credit cards, etc.—by the time they retire, recent statistics show that this is increasingly not the case, and that many are now carrying debts into their retirement years. Of course, debt isn’t necessarily a bad thing in itself, and indeed it can be eminently useful, provided it doesn’t get out of hand and start affecting your lifestyle.
If you own a business, for example, debt can be essential to operations, and life insurance can be useful in retiring that debt and maximizing the value of the business in the event of a sale. Or, it might be used to buy out a partner so the business can be kept in the family or to keep the business afloat while new leadership is hired and brought up to speed.
Another often indispensable use for life insurance is to enable inheritances to be properly equalized when there is more than one heir. In many cases, an estate may consist primarily of a single large asset, such as a cottage or an RRSP/RRIF. As noted, both of these assets will become taxable upon death (except for spousal rollovers of RRSP/RRIFs).
How do you split an asset such as a cottage, especially when family members may have differing opinions as to what should be done with it? One child may want to keep it while another may want to sell and use the resulting cash for other purposes. It can get even more complicated if the one child has contributed significantly to the cottage and uses it regularly while the other seldom goes there. How do you prorate their respective shares? What if there are three or four children with differing opinions to consider? And who is going to pay the tax bill?
The availability of a second source of cash can enable one child to receive the cottage, thus keeping it in the family, and provide the other(s) with an equivalent benefit. In this case, too, it could be reasonable for the child receiving the cottage to cover the tax bill, thereby reducing the size of insurance policy required to balance everyone’s entitlements.
The equalization problem can be even more pronounced when the primary asset in the estate is an RRSP or RRIF and a spousal rollover is either not available or not desired. While with a cottage, the tax is based on the capital gain only and not the entire value, and is applied at half the normal rate, every dollar in the registered plan is fully taxable, and it is the estate that must pay the tax, not the beneficiary.
What can often happen, as a result, is that one child is designated as beneficiary of the plan, while the others receive an equivalent value in cash, but the beneficiary gets the plan tax-free and the other must pay what may be a very sizable tax bill out of their erstwhile equivalent share. The result can be a gross imbalance and a legacy of resentment at the unfairness of it all. Here, again, a life-insurance policy can be invaluable in ensuring that everyone gets a fair share.
It’s worth noting, too, that life-insurance policies can have multiple beneficiary designations, each with its own unique entitlements. If there are several heirs and, say, two large assets that are indivisible—such as real estate—this can further facilitate the equalization process.
“Life insurance also can be used to make donations to charitable organizations,” Cooney notes, adding that the fixed, tax-free status of payouts ensures that the charity will get maximum value from your donation.
And finally, the ability to access cash right away, while the rest of your estate may be tied up for weeks or months in the probate process or, in the case of real-estate assets, the sale process, means that insurance proceeds are a convenient solution to the immediate need to cover funeral expenses.
Choosing the Right Policy
In recent years, partly as a result of our ever-increasing life expectancy, it’s become much easier (and less costly) to buy life insurance in our 60s and even 70s. Nevertheless, if you have the need, the decision should be made as early as possible.
“Generally speaking, the younger you are, the more affordable life insurance will be, so you should buy it as soon as you can,” Cooney says. “Also, if you’re younger, you’re probably in better health, so insurance will be easier to get, and more affordable.”
As for actual premium costs, it’s difficult—and possibly even misleading—to cite specific figures when there are so many variables such as age, health, and lifestyle to consider, and so many different policy variations built around these variables. “We underwrite life-insurance policies based on age and health, but the premiums can vary widely, depending on the type of policy,” Cooney says.
Nevertheless, he cautions against looking at price alone, as this may lead to the purchase of policies that are totally unsuitable for retirees. “Term-type policies, for example, are more affordable, but they’ll expire after a certain period—maybe 10 or 20 years—or there may be a cut-off at a certain age, so they’re not necessarily the best for all situations. And there are always special considerations.
“If you purchase term insurance, over time the premiums can be more expensive than the eventual payout,” Cooney adds. “If you purchase whole or universal life, you get an automatic cash value in addition to the death benefit, and this can make a big difference. And although universal or whole-life policies tend to be more expensive, they’ll last for as long as you live.”
While it may be difficult to get generalized pricing on life-insurance policies, you can now avail yourself of numerous online calculators to get a handle on the possible costs of a policy for yourself. All the major insurance vendors’ websites (including BMO’s) now offer this feature, as do dedicated online brokerages such as insurancedirectcanada.ca, policyadvisor.com, and cpp.ca.
Once you’ve entered the required information on one of these calculators, you may still need to arrange to talk to an agent or broker, either by phone, e-mail, or online chat, to get a final figure that applies to your particular circumstances, but there’s no obligation to buy once you’ve received the quote. And going through this long-distance process, rather than having to arrange an in-person interview, removes much of the sales pressure that typically applies in such situations.
Cooney stresses, however, that it’s important to look at your overall estate plan when contemplating life insurance, and this type of in-depth analysis may not be available online. “There are a lot of factors to consider when it comes to buying life insurance as part of your estate plan, so you need to talk to a financial advisor about whether and how life insurance can be helpful in your particular circumstances,” he says. “You should work with your advisor to make sure a life-insurance policy is appropriate for your situation.”
Of course, it may be that you don’t need life insurance; some retirees, for example, have enough liquid savings or assets to pay off any debts and taxes that may arise and can avoid equalization problems without requiring insurance to fill the gaps. But that’s something that should be discussed with your financial advisor.