Can life insurance fund RRSP estate tax erosion?

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When planning your estate. It is important to consider how taxation will affect the future distribution of your estate.  For individuals that are married, when the first spouse passes away, the assets generally are able to rollover free from taxation to the surviving spouse. However, when the last surviving spouse passes away, all assets are deemed to have been sold at the time of passing, and this includes RRSP or RRIFs.

Leave more wealth to the next generation. As such, registered assets are taken into income in the year of the surviving spouse’s death and taxes must be paid.  These taxes will be due after the death of the second spouse where there are no dependent children. For example, a $500,000 RRSP or RRIF would be reduced to about half the sum after the death of the second spouse (assuming the highest tax rate).  How can this be avoided? How can you leave more of your wealth to the next generations?

A joint last-to-die life insurance policy may be a solution. A joint last-to-die policy insures two lives, usually two spouses for the purpose of paying for an estate’s tax liabilities such as capital gains on a cottage or business. Where there also exists significant family wealth in registered retirement savings plans (RRSPs) or registered retirement income funds (RRIFs), taxes will eventually be due upon the second spouse’s death.  At that time, the entire remaining RRSP or RRIF funds are brought into income. Though this is not creating a liability as such, the taxation of large holdings of registered monies can deplete a family’s overall wealth.

By purchasing a joint last-to-die life insurance policy, the taxation of assets in a family’s estate plan can be offset by tax-free life insurance proceeds.  In the above example, a joint last-to-die life insurance policy for $250,000 would replace the estate value lost to taxation, therefore helping to preserve the estate’s net worth more fully for the family. This is especially true of the RRSP or RRIF owner is expecting to leave the entire amount to his or her heirs.

What about the life insurance premiums?  The premium for the life insurance policy to pay for the estate’s tax loss through RRSP or RRIF final estate taxation is usually a small percent of a significant registered investment portfolio—when compared to the much larger tax bite. The death benefit is tax-free. A joint last-to-die policy can also be structured to pay back all of the premiums that have been paid into the policy, thereby minimizing the cost to the estate for a strategy designed to save money.

Note: It is recommended that you get qualified tax advice concerning taxation of your registered retirement plans if you consider this strategy.

How can life insurance pay off my mortgage if I die?

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Homeowners’ typically insure their mortgage and/or credit line debt with the lending institution which sells creditor insurance. This ensures that the indebtedness would be paid off upon death of the debtor. An alternative route is to purchase a life insurance policy when signing the mortgage papers. Evaluate the following questions when considering buying mortgage life insurance through a lending institution.

  • Are you limiting your life insurance death benefit coverage? 

    The lending institution’s life insurance death benefit is generally limited to the amount left owing on the mortgage (according to its amortization schedule). Conversely, if healthy, most people can purchase an amount well over their home mortgage debt. An increased death benefit could cover multiple liabilities such as increased debt resulting from fluctuating lines of credit, credit cards, or home renovation loans with any creditor.

  • Can you establish or change the beneficiary?Owning your own distinct life insurance policy allows you to designate and/or change a beneficiary who would have the choice of using the money for an alternate purpose, as circumstances require. For example, a surviving spouse may simply desire to keep a low-interest mortgage. He or she would have the option to invest all the life insurance proceeds, or pay off higher interest debt. When using creditor insurance the mortgagee is the only recipient of all of the proceeds.
  • Is the death benefit creditor-proof?If you own the life insurance policy, the death benefit payment is generally creditor-proof. With creditor insurance only your financial institution collects the proceeds at death.
  • Who will own and control the life insurance coverage?You have no ownership or control over a life insurance policy bought only to pay off the debt of a mortgage with one financial institution. It terminates upon repayment of the mortgage; or when you rewrite your mortgage with a different financial institution; or if you sell your house, or a foreclosure occurs.
  • How can I ensure portability of my mortgage insurance? 

    Many people like to shop around for lower interest rates and/or unique mortgages. An individual life insurance policy may be kept as long as you wish, for portability from mortgage to mortgage among different lending institutions, or for other life insurance needs; such as if you were eventually to have capital gains taxed on your cottage or a second residence at death. This can also be pre-funded when you own your own more permanent policy.

  • Can mortgage insurance be cancelled?Personally owned life insurance policies cannot be cancelled by the insurer. However, the creditor insurance may be cancelled upon renewal of the mortgage, especially if one’s health deteriorates. Such a cancellation may mean that you have become an “uninsurable risk” by the next time you renew your mortgage. It is precisely during a health problem that one might choose to increase the mortgage or associated debt (where the home is the collateral in a hybrid type of mortgage with lines of credit, etc.).
  • Can you customize your coverage? 

    Unlike creditor insurance that is directed by the creditor to provide protection for the creditor, personally owned life policies allow individuals to tailor their coverage to their specific needs and requirements. Such flexibility could allow for the inclusion of policy provisions that would allow for the purchase of additional insurance regardless of health, the conversion of a term policy into permanent coverage, or a variety of other customizable options to meet individual needs.

  • Will a surviving joint-owner retain coverage?Creditor insurance may cover two parties who jointly mortgage their property. However, it pays only on the first death, even if the two were to die. When one spouse dies, creditor insurance no longer covers any survivors. In contrast, by owning your own insurance policy, two spouses or partners may each own separate life insurance death benefits. In the case where both parties die, double the benefit would be paid, thus adding increased value to the estate. If one survives, the coverage on that life continues.
  • Can you avoid future insurance medicals?If one is currently healthy it may pay to take the opportunity today to acquire a personally owned life insurance policy––or increase the coverage on an existing plan––and keep it over time. In this way you may be able to side-step the limited future functionality of mortgage insurance offered by creditors. Many group and creditor plans offered by insurance companies are asking for full medicals before initiating the coverage.
  • What about group plans offered at work?Similarly insurance offered by any group benefit plan, especially in light of plant closures, carries the risk that group insurance would be lost at some point. And any plan offered by a bank or a credit card, is actually some form of a group plan with no true ownership, portability, and absolutely no guarantee of long-term continuance.

Note: Before cancelling or excluding the use of creditor insurance, make certain that you are properly protected with a life insurance policy benefit appropriate to your financial needs. In some cases you may need to assign a life insurance policy for collateral at a financial institution. There may be disability insurance coverage included with your creditor insurance that may be important to acquire or retain. There may also be costs or fees associated with cancelling or replacing an existing policy.