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Share the wealth
By Christine Black
The transfer of life insurance between different generations is an effective way of splitting income - without incurring any adverse income-tax results.
An exempt life insurance policy offers you a unique opportunity to transfer wealth to future generations in a way that's tax-effective. You simply purchase an exempt cash value life insurance policy on the life of your child or grandchild, then, when the child or grandchild reaches at least age 18 and has a need for cash, you can transfer the policy to him or her. Your child or grandchild can then withdraw funds from the cash value of the policy to finance major expenditures such as education or the purchase of a home.
 When a life insurance policy is transferred between parties, there is a disposition for income tax purposes, and a taxable policy gain may occur. However, subsection 148(8) of the Income Tax Act makes special provisions in cases where the policy is transferred to a child of the policyholder. Under these provisions, the policy rolls over to the child at the original adjusted cost basis (ACB) of the policy, thus avoiding a taxable policy gain. In this way, a parent can accumulate significant values in an exempt life insurance policy, and, subsequently, transfer the policy to his or her child.
The automatic tax-free rollover applies under the following conditions: an interest in a life insurance policy is transferred to a child of the policyholder; the transfer is made for no consideration; and a child of the policyholder - or a child of the transferee - is the life that is insured under the policy.
Where these conditions are met, the policyholder will be deemed to have disposed of the policy and the child will be deemed to have acquired the policy for proceeds equal to the policy's ACB. Provided that the transfer occurs after the child reaches 18, the child will pay the tax on any policy gain occurring from a subsequent disposition of the policy - for example, by fully surrendering it or by partially withdrawing from its cash surrender value.
For purposes of the rollover, the definition of "child" includes a child of the natural parent, an adopted child, a child of the spouse, a grandchild, a great-grandchild, a daughter-in-law, a son-in-law, or any individual under 19 years of age who was wholly dependent on the policyholder for support and was in the custody and control of the policyholder at the relevant time. The rollover applies only to life insurance policies and does not include annuities.
Under the Income Tax Act, the policy must be gifted to the child - in other words, the child cannot pay anything to the policyholder. This means that if the parent (or grandparent) has an outstanding loan that is secured by a life insurance policy, and then subsequently wishes to transfer the policy to a child, the child cannot assume the loan. By assuming the loan, the child is providing consideration for the transfer of the policy.
The transfer must occur during the life of the policyholder and cannot take place under the terms of an individual's will. In such a case, the policy does not flow directly to the child as required under the rollover provisions, but is first transferred to the deceased's estate. The estate then becomes the policyholder and transfers the policy to the child. The Canada Customs and Revenue Agency (CCRA) has commented that, in such a case, the rollover will not apply, but the disposal may take place at the cash surrender value of the policy.
In order to get around this problem, which occurs on the death of the policyholder, the policy can name the child as a successor owner. Where such a designation is made, the Insurance Act provides that, upon the death of the policyholder, the rights and interests in the policy do not form part of his or her estate. The policy being transferred is therefore not distributed through the will. CCRA has confirmed that the subsection 148(8) rollover will apply in such a situation.
Because an exempt life insurance policy is not subject to annual accrual taxation, it can accumulate significant cash values. Transferring this policy under the conditions described above provides the opportunity for income splitting between parents or grandparents and children. The policy can also be used to fund a child's major expenditure such as university costs.
Consider the following example. Grandfather deposits $5,000 annually for 10 years into a $500,000 exempt universal life insurance policy on the life of his eight-year-old grandson. After 10 years, when the grandson is 18 and attending university, the policy is transferred to him. The grandson withdraws cash annually for five years from the policy in order to fund his education costs.
The accompanying exhibit (p. 43) compares this education plan to an alternative plan where the $5,000 is invested in a taxable investment. It shows that the life insurance plan provides an effective education fund and, in addition, there is valuable life insurance if the grandson wishes to keep this coverage in force.
One of the limitations of using the life insurance intergenerational transfer is the amount of insurance coverage that is available on the child's life. The Income Tax Act limits the amount that can accumulate in an exempt life insurance policy on a tax-deferred basis. Where the life insured is a young child's, there is little room to create a significant cash value. As a solution to this problem, the grandfather could place the insurance on his son, rather than on his grandson. The policy could still be transferred to the grandson on a rollover basis since all of the conditions are met. Although a multi-life policy with more than one insured would also provide additional room for tax-free growth, the rollover provision applies only to single life policies.
Life insurance is often viewed as an important part of every estate plan. The rollover provisions that are available for transfers between generations provide another opportunity to take advantage of the tax-deferred growth of an exempt life insurance policy.
Christine Black, BMath, CFP, CA, is a senior consultant with the Tax and Estate Planning Group of Manulife Financial. She is based in Kitchener, Ontario.
Technical Editor: Ian Davidson, MBA, CFP, CA, Assante Capital Management Limited, Toronto.
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