It’s been 34 years since the government updated the rules for the life insurance “exempt test” – a test that allows insurance policies to benefit from tax-exempt growth. There will be a significant impact to policies issued after December 31, 2016. This edition of TaxBites discusses the changes and the actions you might consider before time runs out.
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There are changes coming to life insurance. But are the changes worth worrying about
The 2016 budget demonstrated the new federal government’s determination to act swiftly and decisively to address situations in which taxpayers, particularly high net-worth taxpayers who are not part of the middle class, might be seen to be taking undue advantage of the tax code. In particular, it reinforced that they will look closely at financial products. Perhaps this is not surprising given that the new finance minister is the former CEO of one of Canada’s largest pension and group insurance firms.
The most significant change coming-up actually predates the current government but, unlike Conservative policies on the TFSA and income splitting, it is not going to be undone by the Liberals. As you may have heard, changes to the “exempt test” for life insurance policies will come into effect on January 1, 2017. This issue of TAXBITES will explain these changes, whether you should care and how you should act given the situation. I’ll begin by defining a few key terms and addressing some common questions. Then I’ll summarize the changes and suggest actions to take.
So what are we talking about? Definitions please!
Term Life insurance: The Income replacement or debt cancellation coverage that most people have. No investment component, no cash value, premiums rise as you age, and it eventually expires.
Permanent Life insurance: Comes in two varieties; Whole Life and Universal Life. Both have no expiry date and have an investment component that grows tax-free within the policy to fund future premiums and/or enhance the death benefit. Policies have a cash value that can be accessed in various ways.
Prescribed Annuities: With so many Canadians living longer these days, many people worry about outliving their savings. Insurance companies have a product called an annuity that mitigates that risk – providing income for life no matter how long you live. Prescribed annuities have the advantage of level taxation for duration of the contract.
Exempt test: Largely unchanged since it was introduced in 1982, the exempt test distinguishes between a policy focused on protection (AKA an exempt policy, no annual tax on growth) and a policy focused on investment accumulation (AKA non-exempt, growth taxed annually). Every policy is tested annually.
Changes to the exempt test: With dramatically improved mortality and a completely different investment climate today versus the 1980s, the government determined that updates were needed to modernize the tax calculations and increase product consistency from one company to another. These changes will affect all policies issued after January 1, 2017 and could affect older policies if certain changes are made after that date. All insurance products will be affected to one degree or another.
I’ve read lots of differing opinions…just give it to me straight!
Do changes to the exempt test mean everyone should buy Permanent Insurance in 2016? Will these policies still be available as of January 1st?
I’ve been contacted by a handful of clients who have heard that Permanent Insurance will not be available as of January 1, 2017. While this is incorrect, it is true that all insurance products will have to be changed to reflect the new rules and in some cases the new products will be significantly inferior to those available today.
The changes have nothing to do with my term insurance so I can ignore them, right?
Although most of the attention regarding these changes has been on the impact to permanent insurance policies, term is affected too. This is especially true for corporately-owned policies whether used as collateral for a loan (a common situation for many owners of professional practices) or if simply designed to flow tax-free funds out of the corporation upon the death of a shareholder.
Do the changes mean it’s better to buy permanent life insurance in 2016 vs 2017.
Yes, by and large this is true, as I will explain below.
Ok, I get it. But what are the changes and what should I do?
Change 1: The amount of long-term cash value that can accumulate in a tax-exempt permanent insurance policy will be lower for policies issued after January 1, 2017.
Action: If you are considering acquiring a permanent insurance policy (Whole Life or Universal Life), it would be preferable to have that policy issued in 2016 rather than 2017. Given that the policy must be in force before December 31, 2016 and that insurance policies can often take three months or more to issue, the effective deadline for new applications is around Labour Day. Conversions of existing term policies to permanent policies could be initiated as late as November.
Change 2: The government’s prescribed “Net Cost of Pure Insurance” is being reduced to reflect the fact that Canadians are living longer. This change has two significant effects on corporately-owned policies:
Effect 1) When a policy is assigned as collateral for certain loans (e.g. to buy a practice), you may deduct the lesser of the premium and the “Net Cost of Pure Insurance” (NCPI). With a lower NCPI, the allowable deduction will be lower.
Effect 2) The change in NCPI will also affect the calculation of a policy’s Adjusted Cost Basis (ACB). As a result, the amount of death benefit that can flow out of the company tax-free will be lower.
Action: If you are considering acquiring a practice in the future, you should look at your term insurance portfolio to assess if it will be sufficient for a lender. If you have a collaterally-assigned term policy that renews in 2017 (or maybe even 2018), you should consider an early renewal to conserve the existing interest deduction and ACB ruleset. If you are looking to use corporate dollars to fund a life insurance policy with the goal of flowing the money to a spouse on death, you should consider acquiring the policy in 2016.
Change 3: The cost of most Universal Life (UL) policies, including T100, will increase significantly in 2017 due to the inclusion of the Investment Income Tax in the premiums. Various measures are being implemented to slow down and reduce the funding of UL contracts.
Action: If you need a lifetime insurance policy and lowest cost and are not seeking growth in the death benefit, a T100 UL policy often fits the bill. The insurance carriers are still working through the product design, but all indications point to the fact that these kinds of policies are going to be significantly more expensive in 2017. As discussed in Change 1 above, there will also be lower long-term cash values that can accumulate in a tax-exempt UL policy and more restricted quick pay options (i.e. fully fund a policy in less than 8 years). UL contracts issued in 2016 will be cheaper and more flexible.
Change 4: The government is increasing the taxable portion of prescribed annuities. As an example, for a 65 year old male, the taxable portion of a prescribed annuity will go from 16.1% to 24.8%. For a 65 year old woman it will increase from 19.2% to 26.2%.
Action: If you are interested in protecting against longevity risk by purchasing a prescribed annuity, it would be better to acquire it in 2016 vs 2017.
From a technical point of view, the changes that will occur on January 1, 2017 are complex, numerous and rather dry for anyone but an insurance actuary. And for many of you, no change to your insurance portfolio may be required. But, there are real implications to these changes that are worth discussing now, before the sun sets on 2016. And that’s what’s most important to me – that we have a discussion to see if any of these changes matter to you, your business or your family. And if so, that we take appropriate action.
Feedback, Comments, Questions
I hope you found this edition interesting and useful. I invite your feedback, comments and questions on any of the above.
The views expressed in this commentary are those of Protect Insurance Agencies Inc. (Protect) at the date of publication, are subject to change without notice, and are not represented to be error free. This commentary is presented only as a general source of information and is not intended as a solicitation to buy or sell specific insurance products or investments, nor is it intended to provide tax, legal or accounting advice in general or specific to your circumstances. Buyers should review all documents relating to any insurance or investment carefully before making a decision and should ask their advisors for guidance based on their specific circumstances. Protect assumes no responsibility for how you use the information you obtain from this commentary. E. &. O.E.