insurance to pay taxes upon death

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demann
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insurance to pay taxes upon death

Post by demann »

What is the accepted wisdom regarding insurance to pay taxes upon ones death?
Insurance brokers are suggesting that I buy some joint last to die permanent insurance ( ie insurance with an investment component tax free if done b4 the end of 2016) . There may be a significant tax bill when the last of my wife and I dies. We have 2 kids ( presently young adults ) . However, it was my thought that if my wife and I live long enough we may use up our assets and simply pay the tax along the way. This however, leaves the kids with not much inheritance. Nonetheless, it will be up to use to determine how much we leave our kids, However, is using insurance with the tax free investment component a good idea? or is it better to just invest the premiums I would have paid the insurance co. and invest the funds I would have put inside the insurance tax free plan and pay any associated tax instead. In the end which option leaves my kids with the most $$, thanks for your advice.
brucecohen
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Re: insurance to pay taxes upon death

Post by brucecohen »

What the insurance salesmen neglect to tell you is that you're paying either way. In the straightforward case the estate pays tax to the govt sometime in the future -- hopefully far in the future if you and wife are in good health. In the other case you pay tax (premiums) to the insurance company starting now. Deflated future dollars versus current dollars. Money out of your pocket versus money out of the kids' bequest.

If the goal is to leave more money to your kids, are they willing to pay the insurance premiums now? They are, after all, the ones getting the asset.

Be aware that the combination of today's low interest rate environment and high fees reduces and even undermines the tax-free accrual inside insurance policies.

Here are the insurance industry guidelines for policy sales illustrations. Make sure you understand them and that your salespeople are in compliance.

While I could see the point of insuring the tax liability on something like a potentially illiquid family cottage with great emotional attachment to all concerned, I question the wisdom of insuring the tax liability on investment assets that are easily sold.

BTW, do you intend to leave anything to charity? If so, the tax credit on that can offset part or even all of the future tax liability.
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kcowan
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Re: insurance to pay taxes upon death

Post by kcowan »

I think you have to get down to specifics. How much tax are you talking about? There are work-arounds for property to avoid probate fees. Charity has been mentioned by Bruce. Buying insurance (a sure expense here and now) to pay extra capital gains taxes when you die only makes sense if the kids cannot afford to do it at the time (such as paying capital gains on a cottage property). I think such a decision should be left to your kids.
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adrian2
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Re: insurance to pay taxes upon death

Post by adrian2 »

One should not "insure" against known events, one should plan for them.

To stretch the example: assume you normally have to pay taxes each April. Does it make sense to buy insurance that would cover those taxes? Assuming such a product exists, would the insurance companies price it such as they would lose money on it or make money out of it, on average?
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iluvnascar
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Re: insurance to pay taxes upon death

Post by iluvnascar »

Yes, I'm a strong believer in life insurance. I have a lot of whole life insurance; as well as several policies for my kids (now about Age 40; purchased when they were very young). And yes, I have heard all those arguments about how you can do better investing it on your own. But whole life has a bunch of advantages which I believe is well worth the premiums.

Looking ahead at the inevitable end, it seemed a no-brainer to pick up some last-to-die insurance. For money that otherwise would have been sitting in a bank account or an investment account, I fork out about $2,200 annually and my estate will get $500,000 tax-free. That's the kind of return I like. The policy was bought when my wife was about 46 years old..........so we (she?) will ultimately fork out perhaps $100,000....or maybe much less.....to get $500,000.

Voila!
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Re: insurance to pay taxes upon death

Post by SQRT »

adrian2 wrote:One should not "insure" against known events, one should plan for them.
This would be my view. It might be as simple as keeping enough cash or FI on hand to pay expected cap gains on death. The more liquid the portfolio the less need there is to plan for taxes on death. I did some work in on my in laws portfolio recently. Cap gains on second to die will be significant, but all the investments are very liquid. In fact I recommended they reduce their cash balances which currently are about 20% of the portfolio and well in excess of any taxes to be paid.

I think Keith's point about non liquid assets (say a cottage) would make sense.
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Re: insurance to pay taxes upon death

Post by OhGreatGuru »

This raises so many philosophical issues about estate planning. But if most of your assets are liquid, and you are not trying to ensure that a very valuable cottage property remains in the family, I don't see what the concern is about taxes due on death. So from that point of view, I think the insurance broker is stringing you a line.

On the 1st death, the surviving spouse can inherit all the investments and defer capital gains until their own death (or sale) of the investments.

Upon the second death, capital gain comes due. But capital gains have an inclusion rate of only 50%, and the maximum tax rate in Canada is 50%, so worst case the estate only pays a 25% tax on the gain on the investments, not the FMV of the investments.

If you die young, there should be plenty of money of money left for your children.

If you die old, your children should no longer need plenty of money.
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Re: insurance to pay taxes upon death

Post by OhGreatGuru »

PS. Insurance agents make quite nice commissions on these kinds of policies.
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Re: insurance to pay taxes upon death

Post by HomePlanet »

While not strictly insurance to pay taxes on death, I am interested in all of your thoughts on life insurance in the following situation.

As background, I have worked in the life insurance industry in the past, and have a solid (if dated) understanding of the product. I have only ever owned term insurance, to protect our children in the event of income loss. My children are near adulthood, so that need has passed, and our current insurance coverage is quite modest. My wife and I are semi-retired, and looking at our investment plan as we make the transition to income from investments rather than work.

I have always been comfortable with a high exposure to equity investments; my wife less so. Given current long term interest rates, I am hesitant to shift much into fixed income now. That said, we have less time and income capacity to manage equity losses. We have maximized RRSP and TFSA contributions. We also have no defined benefit pensions (outside of government programs). And with reasonable return and spending assumptions, we should not run out of assets. So, I am wondering if permanent life insurance offers enough tax advantage to consider it for a portion of our portfolio?

The timing is driven by pending changes in tax rules for permanent insurance, effective in 2017. If we are going to use life insurance, now would be the time. We have received illustrations that show after-tax IRRs over 30 years (roughly our life expectancy) of about 4% for a death benefit and 3% for cash values, with dividend rates reduced 1.5% from current levels. Using current dividend rates, IRRs increase to 5.5% and 4.25% respectively. In the event of premature death, the insurance IRR increases, while extended life causes the insurance IRR to approach the cash value level.

I am skeptical that dividend rates will remain at current levels over the next 30 years, but I do expect them to move in tandem with long-term diversified portfolio returns. They compare favourably with long term bond returns, but are not directly comparable. My hesitation with permanent life insurance in the past has been about locking in an arrangement for the rest of my life. But as that time-frame shortens, my concern lessens as well.

My decision is whether I am prepared to lock into such an arrangement given its expected returns, and various fees and conditions. But as I consider these proposals, I want to make sure I am not missing any important parts of the analysis. If anyone has any thoughts on this arrangement, I look forward to hearing them. Thanks.
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Re: insurance to pay taxes upon death

Post by 8Toretirement »

HomePlanet wrote:While not strictly insurance to pay taxes on death, I am interested in all of your thoughts on life insurance in the following situation.

As background, I have worked in the life insurance industry in the past, and have a solid (if dated) understanding of the product. I have only ever owned term insurance, to protect our children in the event of income loss. My children are near adulthood, so that need has passed, and our current insurance coverage is quite modest. My wife and I are semi-retired, and looking at our investment plan as we make the transition to income from investments rather than work.

I have always been comfortable with a high exposure to equity investments; my wife less so. Given current long term interest rates, I am hesitant to shift much into fixed income now. That said, we have less time and income capacity to manage equity losses. We have maximized RRSP and TFSA contributions. We also have no defined benefit pensions (outside of government programs). And with reasonable return and spending assumptions, we should not run out of assets. So, I am wondering if permanent life insurance offers enough tax advantage to consider it for a portion of our portfolio?

The timing is driven by pending changes in tax rules for permanent insurance, effective in 2017. If we are going to use life insurance, now would be the time. We have received illustrations that show after-tax IRRs over 30 years (roughly our life expectancy) of about 4% for a death benefit and 3% for cash values, with dividend rates reduced 1.5% from current levels. Using current dividend rates, IRRs increase to 5.5% and 4.25% respectively. In the event of premature death, the insurance IRR increases, while extended life causes the insurance IRR to approach the cash value level.

I am skeptical that dividend rates will remain at current levels over the next 30 years, but I do expect them to move in tandem with long-term diversified portfolio returns. They compare favourably with long term bond returns, but are not directly comparable. My hesitation with permanent life insurance in the past has been about locking in an arrangement for the rest of my life. But as that time-frame shortens, my concern lessens as well.

My decision is whether I am prepared to lock into such an arrangement given its expected returns, and various fees and conditions. But as I consider these proposals, I want to make sure I am not missing any important parts of the analysis. If anyone has any thoughts on this arrangement, I look forward to hearing them. Thanks.
You will pay a large fee for permanent life insurance depending on whether you have universal life or whole life products. You are also paying the sales fee on purchase. If you need insurance then term insurance is a better deal. If you are using it as an investment policy then you are paying a premium for management and the insurance component. If you break the policy you will suffer penalties.

If you have a business there might be some advantage through the protection of funds if you are sued.

Insurance should be used for unknown hazards, once you have diminished the hazard you might not require insurance, or require less or more specific insurance such as long term care insurance, insurance requirements should diminish as you age and your finances build to where you can self insure or limit the amount of insurance required.
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Re: insurance to pay taxes upon death

Post by HomePlanet »

8Toretirement wrote:
You will pay a large fee for permanent life insurance depending on whether you have universal life or whole life products. You are also paying the sales fee on purchase. If you need insurance then term insurance is a better deal. If you are using it as an investment policy then you are paying a premium for management and the insurance component. If you break the policy you will suffer penalties.

If you have a business there might be some advantage through the protection of funds if you are sued.

Insurance should be used for unknown hazards, once you have diminished the hazard you might not require insurance, or require less or more specific insurance such as long term care insurance, insurance requirements should diminish as you age and your finances build to where you can self insure or limit the amount of insurance required.
Hi 8Toretirement. Thanks for the reply. I agree with pretty much everything you have posted. I understand that insurance carries a lot of costs that would not apply to regular investments. But as I understand it, there are also tax deferral benefits with life insurance that can, in time, overcome those additional costs. And those benefits will be reduced starting next year. If I am mistaken, I would like to know before proceeding.

As I mentioned earlier, the illustrations I have been given show after-tax IRRs in the 4-5% range. Since policy dividends depend on long term portfolio returns, if future returns exceed expected levels, then dividends (and policy IRRs) should increase as well. And if returns decline, the policy offers certain guarantees setting a floor level for rate of return (provided the policy is held until death). So one question is whether policy illustrations are accurate projections of results based on assumptions. I know in decades past, illustration software was used to produce wildly unrealistic projections, but I believe that things have changed. That said, I have little current experience with life insurance. There are a lot of very sharp people here, so this is a great place to ask.
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Re: insurance to pay taxes upon death

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The timing is driven by pending changes in tax rules for permanent insurance, effective in 2017. If we are going to use life insurance, now would be the time. We have received illustrations that show after-tax IRRs over 30 years (roughly our life expectancy) of about 4% for a death benefit and 3% for cash values, with dividend rates reduced 1.5% from current levels. Using current dividend rates, IRRs increase to 5.5% and 4.25% respectively. In the event of premature death, the insurance IRR increases, while extended life causes the insurance IRR to approach the cash value level.
You might want to check with the salesperson to see if the after-tax IRRs for cash values incorporates the tax bill on the surrender gain (proceeds minus ACB) when funds are withdrawn. I suspect they don't and therefore they are overstated. Also, if available, you might want to look at the year by year IRRs to see how long it takes before a decent after-tax IRR is generated.

There is an investment component in permanent life insurance and there is a tax deferral element to this. However, IMHO, buying such insurance products, which are inflexible, expensive and complicated, whether under the existing or new tax rules, in order to obtain the tax deferral on the inside build-up is generally not a good financial plan. There are investments that contain a tax favoured element, such as preferred shares, common shares, reits, etc. and you can build a pure investment portfolio which should beat the insurance product after-tax IRRs because you won't be paying the cost of insurance charges for the insurance that you don't appear to need.
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Re: insurance to pay taxes upon death

Post by HomePlanet »

SLeazebag wrote:You might want to check with the salesperson to see if the after-tax IRRs for cash values incorporates the tax bill on the surrender gain (proceeds minus ACB) when funds are withdrawn. I suspect they don't and therefore they are overstated. Also, if available, you might want to look at the year by year IRRs to see how long it takes before a decent after-tax IRR is generated.

There is an investment component in permanent life insurance and there is a tax deferral element to this. However, IMHO, buying such insurance products, which are inflexible, expensive and complicated, whether under the existing or new tax rules, in order to obtain the tax deferral on the inside build-up is generally not a good financial plan. There are investments that contain a tax favoured element, such as preferred shares, common shares, reits, etc. and you can build a pure investment portfolio which should beat the insurance product after-tax IRRs because you won't be paying the cost of insurance charges for the insurance that you don't appear to need.
I will confirm whether the IRRs on the cash value do include tax on the surrender gain. Thanks for the suggestion. I thought that they did, as the IRR on the cash value is lower than on a death benefit, but the difference may not be large enough to account for the tax payable. Certainly, the return via cash value is negative in the early years, becoming reasonable by year 20 and leveling out beyond year 30. Buying insurance here really makes the most sense if the intention is to hold the policy until death.

In ballpark terms, this is our situation. Our total assets are made up of about 20% in real estate (mainly our residence) and about 80% in investments, primarily in equities with a global allocation. We have been comfortable with this allocation, but recognize it has risk. One option is to allocate a portion to fixed income. That will reduce volatility, but also expected returns. And to have a significant impact on volatility will require a 40% or so allocation to fixed income.

Given our current assets, lifestyle and realistic returns, we should not outlive our assets. Running Monte Carlo simulations shows a very high probability of leaving an estate. So we are already mentally accounting for a portion of our assets to go to our children. As time passes, we may help them along the way, or support charities to a greater extent than we do now. But there is some hesitation because of an uncertain future.

What this insurance idea does is take about a half of a percent of our assets per year for 20 years, to pay out 20% of our assets as a death benefit. When added to our real estate, that means about 40% of our current estate will still be around, whatever happens to our equity investments. And we will still have about 70% of our assets invested in equities, even if we carve out enough to fund all 20 years of insurance premiums right away.

I see the insurance plan combined with fixed income funding as essentially a 30 to 40 year bond, with 4-5% after tax returns if held to maturity (compared to 2+% before tax for 30 year GofC bonds). I am intending to hold it full term, but the cash value does allow some access along the way, while sacrificing rate of return. That would be available "just in case." But as mentioned earlier about the tax cost of accessing cash values, I want to be sure I am considering all relevant factors before deciding to proceed. As one example, the illustrations I have show different dividend rates, but that just changes the rate of growth over time. I plan to clarify what scenarios can result in the cash value or death benefit of the policy actually declining over time.
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