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Income Splitting and Permanent Life Insurance

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:

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.

Variation

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.

Next Steps

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.

Happy splitting.

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

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About the author: This is a guest post. You can read more about the author in the biography above.

{ 18 comments… add one }
  • FT FrugalTrader March 4, 2011, 10:46 am

    Hey Roland, thanks for the informational post. My question now is all about performance. How does this income splitting strategy with your children compare to other strategies like informal trusts etc? My concern would be the higher fees of the investment choices under a Universal Life policy.

  • Paul March 4, 2011, 2:14 pm

    Isn’t this post contradicting what a previous author said about universal life insurance? When you check the numbers, which most people wouldn’t bother but neither is it provided in this post, this might as well be a very bad deal for you. The insurance guy is just artificially creating a need to sell you this idea that UPL is good, which it isn’t according to http://www.milliondollarjourney.com/universal-life-insurance-part-2.htm

    This lack of due diligence on guest posts is very disappointing.

  • Roland March 4, 2011, 3:34 pm

    Hi FrugalTrader,

    Thank you for the opportunity.

    I should start by saying that this strategy will not appeal to everyone and your concern on higher fees is a legitmate one which I believe deserves some attention.

    I have to say that I completely understand previous posts on why permanent insurance is often oversold, and how there is a plethora of negative attention drawn on “need creation”.

    This isn’t an article to persuade you to purchase permanent life insurance, but to highlight a concept, for those who do covet the characteristics of permanent insurance. Careful planning, and the term vs. perm conversation needs to take place between yourself and a trusted advisor.

    To answer the performance question, most UL policies will allow you to choose from a wide variety of investments inside your policy. They generally include high interest generating accounts, indexed and managed accounts. For indexed accounts, your insurance advisor should note you have to pay an MER up to around 3.5%. For managed accounts, you will pay an average of 2.5% higher. Thus, the total cost will come to about 5%. This is much higher than investing outside as we all know.

    For a moment, take into consideration money invested outside of your RRSP. If is sold at a profit you will realize capital gains and will have to only include 50% of that gain in your income and are therefore taxed on only half of your gain, as opposed to 100% of any interest income that you earn. Thus, from a performance perspective it may be wise to dedicate the interest-generating portion of your portfolio to your policy in order to save tax and avoid paying higher MERs.

    Another nice characteristic of a universal life policy is that you can opt for an increasing death benefit. Thus, the cash value could be added to the death benefit and paid to your beneficiary on a tax-free basis.

    As previous guest bloggers have already stated, every problem can’t be solved with the same solution. In the case of permanent life insurance you need to sit with you advisor and seriously understand the differences between solutions after analyzing your needs.

  • Roland March 4, 2011, 3:53 pm

    Hi Paul,

    Thank you for your feedback. I don’t write articles often, and am familiar with the previous posts. I appreciate your criticism, and if given the opportunity will try to a better job. Hopefully I addressed some of the numbers in my response above.

    My intention was not to create an artifical need or to come across as a sales pitch. In fact, when FrugalTrader and I began discussing the idea of this article, I was very sensitive to his concerns about this being a sales-centric post.

    There were two primary drivers for the article. Firstly, this time of year many individuals are giving thought to things like income splitting. An article I recently read in money sense magazine also raised the idea of this very concept. So, if those individuals are in discussions with their advisor this may prompt them to start some dialogue. Secondly, there are several insurers who have yet to increase their rates. That is just a fact, and consumers should know, once they’ve evaluated and decided to implement the strategy, that they may want to consider purchasing while rates are less expensive.

    Thanks,
    Roland

  • alexander45 March 4, 2011, 4:15 pm

    I don’t get it.

    How does buying an insurance policy on your kids reduce your taxes except in the rather bizarre sense that you will pay less taxes because you have given away your investment income for someone else to pay taxes on (i.e., your kids).

    Do you not need to buy the insurance policy with after-tax dollars?

    Sure, the investment income grows tax-deferred, but it is the kids that get the money, not you. So, yeah, I guess the overall amount of taxes spent on the invested money is less than it would have been if you held on to it yourself, but in essence, you haven’t really “split” your income. You have given away some of your post-tax income by buying the insurance policy, in order that your child can pay less on the invested income than you would pay on it.

    This seems to be only a plausible scenario for extremely high-income earners who already have a tax problem and who are looking to give a big inheritance to children. Do you have a tax problem? Are you planning on giving your kids a huge chunk of inheritance? How many people are already maxing out their tax-deferred options (RRSP, Spousal RRSP, RESP) and/or Tax Free options (TFSA)?

    I can see why this benefits the kid, but how does it benefit the parent?

  • AKip March 4, 2011, 9:22 pm

    I second Paul’s comment. (#2)

  • Jungle March 5, 2011, 1:25 pm

    Buy term and invest the rest.

  • Chris L. March 5, 2011, 5:32 pm

    How can giving money to a child reduce your taxes?

  • Ed Rempel March 5, 2011, 11:25 pm

    Hi Roland,

    Couldn’t the “income-splitting” strategy be done more effectively with mutual funds in trust?

    If you invest in a mutual fund “in trust for” your child and invest for capital gains, they are fully taxable to your child. who gets the $10,000/year personal exemption, so you effectively avoid all tax.

    Ed

  • SilverEggplant March 5, 2011, 11:40 pm

    I don’t quite follow the tax-free transfer of the policy. Isn’t it possible for the fair value of the policy to exceed the parent’s cost base at time of transfer, thus resulting in a capital gain? I don’t understand why there is no tax on the transfer of the policy to the child.

  • Steve March 6, 2011, 1:21 am

    Great guest post Roland. Keep up the good work.

  • Roland March 6, 2011, 2:37 am

    Hi alexander45,

    Thank you for the feedback.

    Prior to even considering the tax-deferred benefits to the child, which in reflection perhaps wasn’t articulated well, is whether the need for permanent insurance exists in the first place.

    You’re correct in pointing out the many other vehicles at your disposal for tax-deferred/income splitting options. With so few income splitting options at our disposal the post was intended to merely point to a feature perhaps overlooked in permanent policies. Moreover, for those who were in the market for permanent policies to let them know that rates are going up throughout the industry.

    The fact that the permanent insurance would primarily benefit the child would actually be the driver. If the need exists for primary insurance then perhaps it could be looked at as an alternative strategy with your advisor.

    Thanks,
    Roland

  • Roland March 6, 2011, 3:00 am

    Hi Jungle,

    In many, many, respects I completely agree with this notion.

    At one point I only owned adequate term, and have increased it at different points in my life. Like most other readers on MDJ I too do my best to invest the rest.

    Having said that, I also took out permanent policies on my children a couple of years ago. I believe that too was a good investment, for them. There are some interesting products on the market now for children that are permanent in nature and for me were well priced. For example, there are whole life plans that combine Critical Illness and Life Insurance for children that have paid-up options.

    For myself, having two children and one with special needs I didn’t have to manufacture a need. It existed and I concluded this was a great investment for them outside of their registered and non-registered investments. I recognize not everyone has this need.

    I also have to stress that my intention is NOT to push permanent insurance where it does not belong. Every situation is unique, although the vast majority are best served obtaining adequate term coverage. Whether you fall into that category is for you to consider with your family and your advisor.

    Thanks,
    Roland

  • Roland March 6, 2011, 3:22 am

    Hi Ed,

    Thank you for the feedback.

    Indeed, the income-splitting strategy you outline has the potential of being much more performant.

    The tax-deferred features would warrant a look only if the need for permanent insurance existed in the first place. As opposed to income-splitting being the primary motivator.

    Thanks,
    Roland

  • Roland March 6, 2011, 3:24 am

    Hi Chris L,

    Thanks for the question.

    I think you are referring to the bullet at the top of the post which was pretty vague on my part.

    I was referring to a several, perhaps lesser known, income splitting strategies which involve giving money to children that I am aware of which you should most definitely review with your tax expert or advisor.

    For example, purchasing stock in the name of your minor. Buying investments for your child at a young age may result in he/she paying capital gains at his her own lower tax rate down the road.

    Check this article out:

    http://www.moneysense.ca/2011/01/19/slash-your-taxes/

    I believe there are several other income-splitting strategies which involve children you might be interested in.

  • Chris L. March 6, 2011, 12:59 pm

    Thanks! Basically what I figured. Best way might be to find some way to have your children actually do work for you…then you can actually keep the money in the family.

  • Kma March 19, 2011, 3:56 pm

    You should also mention the big fat hidden fees and massive commissions the salesperson gets. Be aware when you speak to life reps. They are motivated by money and could give a rats ??? about what you need.

  • keenmachinist March 21, 2011, 8:54 pm

    what do you guys think of “primerica”? not sure if i want to get involved with them, just want to know about thier products without throwing my 5 friends under thier bus

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