Estate planning with life insurance

You may purchase life insurance to protect your family’s well-being in case of your death. But life insurance is also a core aspect of planning your estate.

This article discusses the benefits of incorporating life insurance into your estate planning and how different life insurance policies can accommodate your estate planning needs.

What is estate planning?

Estate planning is the process of anticipating and arranging, during a person’s life, for the management and disposal of that person’s estate during their lifetime and after their death. Estate planning typically involves the creation of a will or trust.

Why do people plan their estates?

There are many reasons why people might want to plan their estate. Some people do it to make sure that their assets are distributed according to their wishes, (like making sure certain charitable organizations receive a donation). Others do it to minimize taxes or probate fees and ensure a larger inheritance for their children or loved ones.

How life insurance payouts work in estate planning

If you pass away with an active life insurance policy, your beneficiaries (such as surviving family members) receive a tax-free cash payout from your insurance company. This payout is not considered part of your income or your beneficiaries’ incomes and is not taxed as such when you pass. This is because you paid your life insurance premiums using funds on which you paid income tax as well.

The insurance provider ensures that payouts go directly to your beneficiaries. The payout bypasses your estate and the probate process. As a result, if you have outstanding debts at your death, creditors can’t access this death benefit unless the payout goes to your estate.

Further, because your life insurance benefit skips the estate process, the payout is free from probate fees — also known as estate administration tax. The fee varies depending on your province and the value of the assets in your estate. For instance, Ontario’s probate fee is $15 on every $1,000 of assets over $50,000. While $15 looks minor, a death benefit of $1 million could incur a probate fee of $14,250 if it goes through your estate.

Can a life insurance death benefit pay for estate taxes?

Yes, a life insurance benefit can help pay or fully cover estate taxes. Estate taxes can be a large financial burden on your loved ones and an unexpected expense if you suddenly pass away. When you die, there are common estate taxes that come in the form of capital gains. A capital gain occurs when you sell an asset, such as your cottage, for more than the purchase price. The difference between your purchase price and the sale price is the capital gain. In Canada, 50% of the capital gain is taxable at your highest marginal tax rate.

So, if you purchased a cottage for $100,000 and sold it for $150,000, you would have a capital gain of $50,000. Half of that amount, $25,000, is then added to your taxable income for the year.

Common assets considered part of one’s taxable estate:

• Real estate
• Cash
• Investments
• Mutual funds
• Property (Art, jewelry, cars, etc)

How do capital gains on properties work?

When you pass away, Canadian tax laws consider your assets to have gone through a deemed disposition. A deemed disposition assumes that, for tax purposes, your assets are “sold”, and a capital gain is triggered. An exception is if the beneficiary of your assets is your spouse. In this instance, there’s a “rollover” that allows your spouse to receive the assets without paying capital gains tax.

But, if your children or other family members receive your assets as part of your will, a tax consequence will likely arise. With the value of real estate properties appreciating so much over the past decade, a deemed disposition of the family cottage or rental properties could mean a significant capital gain and a significant capital gains tax.

If your family doesn’t have enough cash to pay the capital gains tax at the time of your death, the situation could force them to sell the cottage or other assets.

However, life insurance proceeds can provide an immediate source of liquid cash upon your death to pay these taxes. It’s common for individuals to purchase life insurance so that their beneficiaries can prevent a forced sale of cherished assets, like the family cottage.

How do capital gains on a family business work?

If you own a business, the value of its assets may have increased over its years of operation. This can create a tax consequence when you die.

When you die, there’s a deemed disposition of your business’ assets, which can create a massive tax bill for your beneficiaries. Like the capital gains of your cottage, your beneficiaries may have to sell the business to pay the affiliated taxes. A death benefit could help provide cash to remedy the situation.

An alternative is to implement an estate freeze, which can “freeze” the value of your business’ assets for tax purposes and defer the tax payable to the next generation or whenever your family chooses to sell the business. However, estate freezes are a complicated area of tax law and require expert lawyers and accountants, which can cost a lot of money.

How is a Registered Retirement Savings Plan (RRSP) taxed at death?

At death, the full amount of your RRSP or Registered Retirement Investment Fund (RRIF) is added to your final year’s income and is taxed as such. This can create a significant tax liability for your estate unless your situation qualifies for the exception.

As previously mentioned, if neither your beneficiaries nor estate has enough cash to pay estate taxes and fees, it may mean selling the assets in your RRSP or RRIF. Although selling RRSP/RRIF assets might not have the same emotional ramifications as selling the family cottage or business, it may not be preferable to sell if there’s a market downturn. Having cash on hand, such as that from a death benefit, can prevent the need to sell RRSP/RRIF assets at a less-than-ideal time.

What end-of-life expenses can life insurance cover?

Life insurance can cover your funeral costs, outstanding debts, and financial goals.

The average Canadian burial costs between $5,000 and $10,000 while the average Canadian cremation costs $2,000 to $5,000. If your estate doesn’t have enough money to pay for your funeral, it can leave your surviving family members with a hefty bill. To ensure that your family won’t have novel financial stresses in addition to the emotional stress of your death, a life insurance policy can be there to pay for your funeral costs.

A death benefit can also cover outstanding debts, such as a line of credit or mortgage, so your family won’t need to worry about these either. Alternatively, it can help surviving family members reach financial goals such as saving for post-secondary education or buying their first home.

What are the best types of life insurance for estate planning?

The best type of policy for estate planning depends on your needs and budget. Both term and whole life insurance provide payouts when you die. But whole life insurance (or a permanent life insurance policy) is often more effective in estate planning because the policy lasts for your whole life. Term life insurance only lasts for a particular term (10 years, 20 years, etc). Therefore, term insurance would only work as an estate planning tool if you die within that time period.

Term life insurance may be more affordable than whole life insurance, especially when you’re young. But if you pass away after the term expires, your family still has to deal with costs associated with your death with whatever’s left in the estate. This could force them to sell the family cottage or pay your funeral expenses themselves. This isn’t an issue with permanent insurance because the “term” essentially lasts as long as you pay the premium.

Other policies, like a universal life policy, are not well suited for estate planning and are more so a wealth-building tool as it requires constant monitoring and offers uncertain returns.

Learn more about term versus whole life insurance and universal life insurance.

Ultimately, the insurance company and policy that best suits your estate and your other needs depends on many factors. Reach out to one of our expert advisors below to discuss your life insurance needs and find what policy may be right for you. You’ll also receive no-obligation, custom quotes from more than one insurance company for any coverage you’re seeking.