Preparing for 2016 – Changes to the Taxation of Life Insurance, Prescribed Annuities and Testamentary Trusts
For those of us who focus on estate and financial planning, particularly on the left coast, the last few years have featured a cavalcade of change. 2011 featured changes to how Powers of Attorney must be set up and what they can do, along with the introduction of a new healthcare document called an “Advance Directive” that allows you to dictate your healthcare choices in advance along the lines of a Living Will. 2013 marked large scale changes to family law in beautiful B.C., such as extending property rights to common law spouses and changing how property gets divided in the event of a divorce. This year (2014) saw massive changes to Wills law, including a change on how things get divided if you die without a Will, what happens if two people die around the same time and removing the automatic revocation of your Will upon marriage, to name just a few.
Despite the significant changes already in place, there more still to come. This time they’re coming from the Federal Government and will affect more than just those people who cheer for the Canucks. Fortunately, we’ve been told of these tweaks to the system several years in advance so that we get a chance to either prepare for the inevitable (such as under the new tax rules for how trusts set up in your Wills) or to take advantage of a final chance to buy life insurance and annuities that will continue to qualify under the current rules even under the new regime. Here’s a little bit about each.
Changes to Life Insurance
Anyone with a passing knowledge of the sales business knows that instilling a sense of urgency is often the final push that propels someone from analysis paralysis to signing in triplicate. In the life insurance world, the most common calls to action are:
(a) when you are approaching a birthday, as you’ll probably get better rates if you take out new coverage or convert an existing plan before that happy day;
(b) as your existing term coverage approaches expiry and the sticker shock of renewing without additional testing causes you endure more needles and specimen jars in the hopes that applying for new coverage rather than continuing the old can result in substantial savings;
(c) when your 65th birthday (and the last chance you may have to convert existing term coverage to permanent protection) looms large on the horizon; and
(d) after someone you know has died or had had a close call.
Here’s one more bugle call to cajole you into pulling up your insurance advisor’s contact details on your cell phone: current permanent insurance policies will have a significant leg up on those purchased after 2015. In other words, while existing policies are safe from these new restrictions and regulations, the new lay of the land won’t be quite as pretty for clients purchasing permanent insurance policies in 2016. I’m focusing on universal life policies for the discussion below but the rules will also affect other permanent policies with a cash value, such as limited pay and participating whole life policies as well.
With no further fanfare, here are a couple reasons why if you’re looking at permanent insurance with a desire to build up significant cash values, now is the time to act:
• the amount of extra money can be squirrelled away inside permanent insurance policies won’t be as high for new policies. In the high end market, many insurance policies contain a cash value that can be used to supplement retirement income or increase the eventual payout at death. The main benefit of this strategy is that it allows the extra contributions inside the policy to not only grow tax-free during life while kept inside the policy and to be eventually paid out tax-free at death if they remain inside the policy.
For those people hoping to use the money for retirement, withdrawals will be a blend of tax-free returns of capital and income (even if invested in funds that would normally pay out dividends and capital gains), depending on a variety of factors. Some clients are able to get around this tax event by using the cash value of the policy as collateral for bank loans that likely won’t need to be repaid until death when the money can be paid out tax-free. This ultimately means replacing a tax bill that could approach 50% for some of us if investing in a non-registered account or what we’d have to pay on the taxable part of a withdrawal from the policy for an interest charge of perhaps 5% at this point. As you can imagine, for clients in a higher tax bracket, this ability to grow money tax-free and receive all or some of it tax-free in exchange for a modest interest charge is an outcome that makes their eyes light up with glee and their hands get a little sweaty.
Accordingly, any reduction to what they can tax-shelter in future policies is a bad news story. For clients that still want to take advantage of these inherent advantages, this will mean accepting that they won’t be able to shelter as much money as is allowed under the current rules for a policy of the same size or having to buy policies that provide a higher death benefit, which means paying higher insurance premiums. As many clients are purchasing the policies to build the cash value, any increase to what they have to pay in premiums means less money left to bump up their retirement fund or to use for other purposes.
I also worry that lower cash values increases the chances of things going wrong 15 or 20 years down the line, even more so when clients increase their insurance coverage and costs in order to buy more room for tax-sheltered growth. Many policies are marketed on the premise that you can pump in many times the basic premiums over the first 10 years, after which time this extra money and the investment growth on it will be enough to pay the yearly insurance premiums while still growing the cash value. As this happy event is also often based on future investment returns, which are, at best, an educated guess, things can go a little sour if the stock market doesn’t cooperate or the clients aren’t able to pay in as much as they initially believed. Thus, lower cash values mean less wriggle room down the road. This problem is magnified if clients now take out larger insurance policies with larger annual premium expenses, which can eat away at the cash balances so much quicker. Making it even scarier, these problems often come to a head well into retirement when we are at our most cash-strapped. In some cases, this can even mean having to reduce the amount of death benefit or even cancelling the policy, thus forfeiting protection you’ve paid for over decades in exchange for essentially pennies on the dollar.
Ultimately, I think that there will still be a huge place for permanent life insurance and planning for policies with cash values even after the new rules come into place but I also believe that current policies, which will remain subject to the current rules even after 2016, will offer a significant advantage over future creations.
• Single-pay policies will be essentially eliminated. There is a lot of grey when interpreting current life insurance tax rules, which is one of the things that the changes are hoping to eliminate. These current shades of grey mean that some companies are able to construct life insurance policies where you can dump in a single huge initial premium, all of which is tax-sheltered, and you’re theoretically done paying into the policy for life (again, assuming that the investment gods cooperate). Part of this magic is accomplished by initially purchasing more insurance than is initially needed and having this amount decrease yearly to either a preset minimum or to the minimum amount each year necessary in order to shelter the current balance of the accumulating fund.
The remainder of the trick is related to charging huge cancellation fees over the first several years which the insurers can deduct when calculating the balance of your cash fund when calculating how much you can tax-shelter. The money deducted for surrender charges is still actually growing in the fund for you but your insurer is able to pretend that it isn’t. Of course, if you do have to cancel within the first few years, things get ugly for you, which you need to know going in. On other hand, these surrender charges soon start to decrease and will eventually disappear so that you won’t be penalized if you make future withdrawals after they have disappeared for good. Obviously, it’s pretty important to understand how that all works in advance and when these charges will vanish.
From 2016 onward, insurers won’t have the same latitude to discount cancellation charges when determining how much money you can sock away in the investment portion of your policy. When this is coupled with other rules that will restrict the size of your accumulating fund, I don’t expect to see single-pay policies on the menu when future clients are discussing their life insurance options. To be more precise, I don’t expect to see single-pay policies that offer full tax sheltering. There are currently insurers that offer a single-pay product where only part of the money is tax-sheltered and the rest invested in a taxable account until tax-free room frees up. I expect that some insurers will continue to offer this option when the rules change but it’s not one that gives me a great deal of excitement. In most situations, I’d rather hang onto the money that can’t be tax-sheltered and only hand it over to the insurers when the room to shelter it in my policy finally opens up.
Prescribed Annuities – What Are They, How They Work and How Are They Changing
I have another article on this subject exclusively almost ready to go but I wanted to take this opportunity to set the stage so that those of you affected get as much time as possible to spring into action in advance. In a nutshell, here’s what they are and how they are going change. Prescribed annuities have been around for many decades. The customer makes a single large payment from non-registered funds (i.e. outside of an RRSP or RRIF) to an insurance company in exchange for a series of smaller payments that are guaranteed for the life. Part of each payment is tax-free and the rest is taxed as income. For most other types of annuities purchased outside of a registered plan, the amount that is taxable and tax-free will vary, with more of your money taxed as income early on. In many ways, it’s like a mortgage – more of the payments are interest in the early years but, as time goes by, more of each payment is classified as a repayment of principal.
For prescribed annuities, different rules apply. The government makes life simple; your payments are not only identical for life since you can’t buy indexing for this type of annuity and so is the percentage of what is income and what is tax-free return of capital each year. In other words, if you get $1,000 per month for life and the taxable portion is $100 and the remaining $900 is tax-free, this will never change. Not only is this a wonderful thing because you get to delay paying tax on all the income that would have otherwise been due early on but it’s also a lot easier to manage your tax bill in advance if you’re dealing with fixed numbers.
If this isn’t enough, there is a final bonus, and that is what is changing in 2016. As I just finished explaining, the taxable / non-portion is etched in stone from the date of purchase onward. To calculate this amount, the government estimates how much you’ll receive over the life of your annuity in total payments and calculates how much this will exceed the amount of your original investment. To do this, they use a mortality table that is older than some of my readers. Ultimately, this means that they’re assuming that you’ll die a lot sooner than current numbers suggest and receive less payments along the way. As a result, they giving us a real break when calculating the taxable portion of prescribed annuity payments. In the case of men around 80, as the old mortality tables assume that you should already be dead by that point, you may actually get each and every payment tax-free! Unfortunately, if you pay for a guarantee period (i.e. ensuring that someone will get a minimum number of years’ payments dating from the time you purchased even if you’re not longer around), that would change the picture slightly.
Unfortunately, in 2016, they are updating the mortality numbers so that anyone purchasing an annuity beyond that date will be stuck paying more taxes each year. What does that mean for you? Simply put, if you buy a prescribed annuity before the end of 2016, your annuity will be based on the old tables and that won’t change. If you buy one in 2016 and onward, then your gross payments from the insurers probably won’t change, as they’ve kept their tables current. Unfortunately, you’ll be stuck paying more tax each year because your tax bill will be calculated according to the new government tables and they’ll be assuming that you’ll be getting paid for a lot longer than they’ve assumed to date.
Changes to the Taxation of Testamentary Trusts
This change is going to affect most of us who decide to leave an heir’s inheritance in a trust rather than distributing it to them directly. The current rules provide a significant tax-saving opportunity if the money is taxed inside the trust rather than in the hands of the beneficiaries. This is because income taxed in the trust’s hands is taxed on a separate tax return filed by the trust that looks a lot like a personal tax return. Although it doesn’t get the personal tax exemption that allows us to earn our first $10,000 or so dollars for free, the trust’s income is calculated using the same marginal tax rates that we use for our personal tax returns. This means that if the beneficiary is a high tax rate, it’s possible that there can be a huge tax savings if the trust pays the income instead and either keeps the money in the trust or writes the beneficiary an after-tax cheque that won’t be subject to future taxation in the beneficiary’s hands. This benefit can extend even further since this post-tax cheque won’t affect OAS pension entitlement or many other income-related benefits a beneficiary might receive.
Unfortunately, in 2016, any income taxed in the trust’s hands will be taxed at the highest personal marginal tax rate for the province in which the trust resides. This means that trusts will probably be forced to pay out more of the taxable income to the beneficiaries if they are in lower tax brackets so that it’s taxed in their hands, as the trustee can also elect to pay out a larger pre-tax cheque and have it show up on the beneficiary’s tax return. They will need to do this to save on taxes under the new way of doing things. Income kept in the trust will be taxed in most cases in the trust’s hands under the new rules and will mean significantly bigger tax bills. Accordingly, it no longer makes sense for trusts to foot the tax bill most of the time.
Unfortunately, unlike the changes to insurance and annuities, trusts in place before the deadline will still be subject to the new rules in 2016. Furthermore, there are a few other changes that will hurt the tax cause, such as these trusts are now required to use a calendar year end, which reduces a few tax-saving opportunities and these trusts no longer get to avoid something called the Alternative Minimum Tax, which most commonly applies when someone sells shares in a small business that qualified for the lifetime capital gains exemption.
On the other hand, there are a few saving graces. First, trusts created in Wills for disabled persons will still be able to use personal marginal tax rates in the right circumstances, regardless of when they were first funded. Second, if your Will calls for outright gifts, income taxed in the estate’s hands will still qualify for marginal rates for the first 36 months after death under the theory that this is ample time to wind up most estates and as perhaps a way of easing our pain just a little bit. Third, arguably the most significant tax saving opportunity still exists if the trust is set up for a host of potential beneficiaries in different tax brackets, such as a child and his own family. Although it will no longer make sense for a trust to pay the tax bill on earned income most of the time, it is still an extremely efficient way of minimizing a family’s combined tax bill. This can be done by allowing the trustee the discretion to distribute the trust income and capital among the various beneficiaries. If some of the beneficiaries aren’t otherwise paying any taxes or are in lower tax brackets than the person you’d have otherwise given the money to directly, the family’s combined income tax bill can still be staggeringly smaller in the right circumstances. For example, if you would have left part of your sizable estate directly to your oldest daughter who is in the highest tax bracket, the net bill will be a lot smaller if it went into a trust she controlled and she used it to distribute money that would have otherwise been taxed in her hands into her kids’. I’ve commented on this strategy previously in another post so I won’t say any more about this now, other than to assure you that this option remains alive and well despite the upcoming changes.
Here are a few additional thoughts regarding the new state of affairs regarding the taxation of testamentary trusts and a few suggestions:
• If you have significant capital gains inside a testamentary trust that is already in existence, you may wish to trigger some of them this year or in 2015 while your trust still qualifies for marginal rates. Yes, it means paying tax early, which is not something I love, but it might be better to take your medicine now at a substantially lower rate than have to deal with it later, especially if the trust beneficiaries are all in relatively high tax brackets and you’re planning on selling some of the trust assets in the next 5 years or so;
• Although we’ve been talking almost exclusively about the tax benefits of trusts, there are many, many other reasons why trusts make sense in certain situations, which I’ve also discussed in the past. Some of these include protecting disabled, younger or financially unsophisticated beneficiaries from themselves, creditor protection and controlling where the money goes after the primary beneficiary dies. For example, in a blended family situation, a trust for the new spouse that allows him use of the asset for life but distribution to your children from the first marriage afterwards may be the perfect compromise between taking care of the new family while protecting the children from the old one.
• Graduated tax rates will still apply for trusts set up people qualifying for the disability tax credit. As the future is an unknown, it may be the case that someone who is hale and hearty now qualifies for disability status later, particularly as they advance in years. Accordingly, you might want to consider still using a trust for that person’s benefit in the event that they are disabled at the time of your death but set it up so that it can be easily dismantled if it doesn’t serve any discernable purpose after you’re gone.
• The impact of the 21 year rule, which triggers a deemed sale and capital gain bill inside most testamentary trusts every 21 years, will be a lot more onerous going forward, since the gains will be taxed exclusively at the highest marginal rate in that province. Accordingly, some existing Wills may need to be tweaked during your lifetime so that there is more latitude to roll assets out of the trust in order to avoid paying the piper or so that they are not in existence as long as originally envisioned.
• Trusts that don’t necessarily distribute all earned income that year may need to be rethought since money kept inside the trust will be taxed at the highest rate going forward. Alternatively or in addition, trusts may now own more investments like corporate class mutual funds that are designed to convert as much other types of income to deferred capital gains. Unfortunately, changes to other tax rules that I haven’t inflicted upon you today will erode their ability to do this as comprehensively as they’ve done in the past, particularly if you’re investing in funds that would normally pay interest income if not for the corporate class structure. If this is particularly troubling to you and have your heart set on owning the most tax efficient corporate class funds going, I do suggest investigating Nexgen, since their structure won’t be impacted by these other tax changes. REITs that can distribute most of their repayments as return of capital may also become particularly popular in the trust world.
• Going forward, other planning techniques to get around or minimize the impact of this new bigger tax bill that will now apply every 21 years will be far more important. In some extreme cases, trustees of existing trusts may be forced to apply to court to vary the trust terms in order to avoid that now far more expensive day of reckoning such as by speeding up when money can be rolled over to beneficiaries or winding up the trust completely.
• Beneficiaries of existing testamentary trusts may need to buckle up and get ready for significantly higher tax bills going forward since it will be usually be more tax efficient for the trusts to pass the tax liability onto these beneficiaries. This can also mean seniors used to receiving their full OAS pension cheques may now be subject to the claw back or may lose other income-related benefits. If this is you, you might want to shift around your existing portfolio before 2016 if this allows you to pay less tax on those gains now and potentially select more tax efficient investments or those that produce more deferred capital gains later. Your accountant or financial planner may also have tax planning suggestions. Unfortunately, for some of this, this may affect our retirement budgeting as well.
To misapply a quote from Faris Bueller’s Day Off, “Life moves pretty fast. If you don’t stop and look around once in a while, you could miss it”. In this case, what you’d miss is a final chance to take advantage of the current tax rules regarding life insurance and prescribed annuities or to minimize the impact of the new rules for testamentary trusts. On the latter front, this may mean you may need to check your current Will if your plans are particularly complicated to see if what you have in place still is the best option under the new rules. If you’re already the beneficiary of a testamentary trust or a trustee of one, you probably have a lot more work to do, such as retuning either or both your personal and trust portfolio. It could also mean triggering capital gains earlier than planned if that can save you big tax dollar going forward. It might also be a really good time to get some tax and planning help to see if there are other ways of dealing with the new tax consequences. Ultimately, most of the impending changes won’t affect most of us. On other hand, for those of us that are affected, taking a few steps now can make a pretty significant difference later.