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Written by: Jeff Sniderman, MBA, CFP, TEP, EPC, CLU, CH, F.C., Estate Planning Specialist and First Vice-President at CIBC Wood Gundy Financial Services Inc.
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As many professional advisors are aware by now, the 2012 Federal budget introduced changes to the taxation of insurance contracts. These changes will apply to life insurance and prescribed annuities settled after December 31, 2016.
The primary changes are to the exempt test and the calculation of the adjusted cost basis (ACB) for life insurance contracts, and to the calculation of the tax-free portion of prescribed annuity payments. Brief descriptions of the changes are set out below, including their implications particularly with respect to philanthropic strategies using life insurance products.
The exempt test:
The new rules will not allow for "quick pay" life insurance where a policy is fully funded in less than eight years on a tax-exempt basis. By contrast, current rules permit policies to be paid up in as few as two years, particularly for older ages.
For donated policies issued after 2016, this limitation may result in a longer funding period where the product is only available as an exempt policy, or result in a higher funding cost for a policy using a level death benefit and increasing cost of insurance. Of course, the donor may decide to make a single lump sum donation which will fund all future premium costs, though this procedure will not eliminate all of these issues.
Calculations of the ACB:
The ACB of a life insurance policy is basically calculated by adding the premiums paid, excluding the cost of ratings and riders, and subtracting therefrom the net cost of pure insurance (NCPI) which is based on the net amount at risk (NAR) and mortality tables. For new policies, the NAR will be based on a prescribed reserve resulting in a lower NAR than the current methodology. This change, in combination with reduced mortality rates based on updated actuarial tables, will result in a lower NCPI and a correspondingly higher ACB.
There will be a negative impact on corporate-owned life insurance because it will take longer for the ACB to be ground down to zero, thus decreasing the credit to the capital dividend account when the death benefit is paid. This is particularly impactful for universal life using a minimum-funded level cost of insurance where under the new rules the full capital dividend treatment may be delayed by as many as 15 years or more depending on the age of the insured. While the higher ACB will be beneficial for policy loans and dispositions, including the donation of a policy, it will have a negative effect where the purpose of the policy is to provide a tax-free conduit for corporate capital to the estate enabling a larger testamentary donation.
Prescribed Annuities:
The attraction of prescribed annuities in a period of low interest rates is based primarily on the generous non-taxable return of capital (ROC) treatment applied to the annuity payments for annuitants at older ages. The updated mortality tables which will come into effect after 2016 have longer life expectancies. This change will spread the ROC over more years thus reducing the proportion of ROC (and correspondingly increasing the taxable portion) in each payment and increasing the age at which 100% of the payment is ROC.
While there will not be any impact on a donated annuity funding a charity-owned insurance policy, it will be detrimental to a donor who, as part of a charitable annuity strategy, is receiving annuity payments to replace lost interest or dividend income from donated capital.
Summary:
These changes are neither draconian nor create immediacy for advisors to bring these issues to the attention of their clients. It is still important to be aware that some donation strategies using life insurance products will be negatively impacted by the new rules for policies settled after 2016.
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