This is a guest post by Roland Chan, an insurance professional.
By now, most MDJ readers will know that income splitting is an effective way to reduce your income tax bill by diverting income from a high tax-bracket to a low tax-bracket family member. By treating tax reduction as a “family affair” you may be able to reduce the taxes you pay.
Some of the better known income splitting strategies include:
- having the lower income earner do the investing,
- contributing to a spousal RRSP,
- invest in an RESP for your child
- give money to a child
There are very few exceptions to the restrictions surrounding income splitting, and you should always consult the advice of a tax expert and document the strategy. Having said that, one often overlooked strategy is the use of a permanent life insurance policy, either whole life or universal life, to split income with your child or grandchild.
How does it work?
It starts by purchasing a permanent life insurance policy on your child or grandchild. Aside from lifelong, permanent, insurance coverage, a portion of your premiums goes towards a cash value account that grows tax-deferred over time. This is the primary reason why premiums on permanent policies are higher than their term insurance alternatives.
The cash value grows deliberately slow at first and will generally pick up earnings after several years. You should always consult your insurance agent to show you the illustration on your permanent life policy in order to understand the possible outcomes. Keep in mind that the primary advantage is that each year there is growth in the cash value it will be on a tax deferred basis. In other words, your interest gains are not taxable until you make a withdrawal from the policy.
Once your child or grandchild becomes of age, you can then transfer the policy to them tax-free. If the child or grandchild then decides to withdraw from the cash value in the policy they will be taxed at their, likely lower, marginal tax rate. Perhaps more importantly, there will be no tax attribution to yourself and you have effectively split your income.
Aside from the obvious tax benefit, it may be a complimentary or alternative way to assist a child in saving towards the purchase of a new home or funding their post-secondary education.
A variation of this strategy may be to take a permanent policy out on yourself. When your children are of age, you may decide to take the cash value out of the policy at that time or have your children continue paying the premiums.
The former will result in you paying tax on the withdrawals if the amount withdrawn is greater than the adjusted cost basis of the policy. So another strategy may be to use the policy’s cash value as collateral so no taxes need to be paid.
If your children elect to continue to pay the premiums this will essentially allow your children to inherit the entire amount tax-free once you pass away.
Why now may be the time to implement
If you are from the school that you won’t need life insurance at a later age when your kids have left the nest and you have effectively self-insured yourself financially, then term insurance may be right up your alley and the notion of income-splitting via life insurance may not appeal to you.
On the other hand, for those who covet permanent life insurance for its investment and estate planning characteristics, or may have exhausted all the other income-splitting strategies and have not yet purchased a plan you may want to consider doing so soon.
Many of the industry’s leading manufacturers of insurance have already significantly raised their premiums in light of the current economic climate by as much as 22%. This low interest rate economy has prompted insurers to revisit their product shelf due to the dismal rate of return on universal and whole life products.
Moreover, if you own a term policy from one of the insurers who’ve yet to raise their rates, and have decided to lock-in a permanent plan by converting your existing policy in the near future, you may want to consider doing so a little earlier in order to take advantage of the lower premium rates.
Consult your financial advisor or insurance agent to determine if this strategy makes sense for you after reviewing your needs. If so, and now is the right time to implement, have them review the insurance manufacturer landscape to determine which of those companies haven’t raised their rates.
About the Author:Roland J. Chan is a husband and father of two living in Ontario. An entrepreneur and current Director of Operations for Liland Insurance Inc. in Toronto, Roland has been a licensed insurance professional since 2002. With the aid of a fantastic team he oversees over 100 life insurance agents. When not spending time with his family he enjoys discourse about culture, technology and personal finance. Follow him on twitter @rolanchan. E&OE