1 INSURED RETIREMENT PROGRAM
2 INSURED RETIREMENT PROGRAM One of the challenges faced by individuals who earn a higher income is finding tax efficient ways to save for retirement. In order to maintain the same standard of living after retirement as they enjoyed prior to retirement, experts most often suggest that 70% of pre-retirement income is required. Government plans and registered plans provide sources of retirement income but income tax rules cap the amount that can be contributed to (or in the case of defined benefit arrangements, received from) employer-sponsored pension plans (RPPs) and individual Registered Retirement Savings Plans (RRSPs). In fact, once earned income exceeds a specific amount, potential RRSP contributions for the next taxation year will be capped. This guide will discuss a strategy for dealing with the retirement income gap mentioned above. The option combines two financial vehicles, an exempt life insurance policy and a loan arrangement. This option will be referred to as the Insured Retirement Program (IRP). TABLE OF CONTENTS Sources of retirement income 2 Three ways to access investment accounts in retirement 3 The IRP concept Collateralization 4 How much will the financial institution lend against the policy? 4 Who should consider the IRP strategy? 4 Factors and risks to consider 5 Using a corporation to own and leverage the life insurance policy 6 Deductibility for tax purposes 6 General Anti-Avoidance Rule (GAAR) 6 Conclusion 6 SOURCES OF RETIREMENT INCOME Registered Plans There are a number of retirement savings vehicles that are regulated by tax and pension rules. There are tax-assisted programs to which individuals and/or their employers might contribute to help accumulate a retirement nest egg. These would include: Registered Pension Plans (RPPs), Deferred Profit Sharing Plans (DPSPs), and Registered Retirement Savings Plans (RRSPs) The Income Tax Act ( ITA ) places limits on the tax assistance for registered plans. Tax assistance means the tax advantages that an employer and/or employee will receive because contributions are tax deductible and the income/growth is not taxed until withdrawal from the plan. Government Programs There are also government-administered programs that provide retirement income based on employment and/or residence in Canada. These programs include: Old Age Security (OAS) and, on a needs basis, Guaranteed Income Supplement (GIS) Programs established by the provinces (e.g., Ontario s Guaranteed Annual Income System (GAINS)) Canada Pension Plan (CPP) and Quebec Pension Plan (QPP) 2
3 Non-Registered Plans Once contributions to (or benefits received from) tax-assisted plans are maximized, those who want to ensure additional sources of funds are available in retirement must find alternate vehicles. Non tax-assisted programs that an individual or their employer might establish which would be a source of retirement income include: Various stock plans Various profit sharing plans Personal savings vehicles/investment portfolios Tax Free Savings Account (TFSA) With the exception of the TFSA these non-registered savings mechanisms often produce income that is taxable annually. A tax deferral is available for investment in stocks that are held for the long term rather than being traded from time to time. As long as no gain is realized, no income tax is due. However, since most people use mutual funds (or segregated funds) as their vehicle for investing in stocks, and since the underlying assets are generally actively traded, gains are realized each year, triggering taxation. Regardless of which approach is used, there will come a time when the underlying stocks must be liquidated, either to produce an income or on the death of the owner or spouse, thus realizing the gains and triggering taxation. Tax Free Savings Accounts (TFSA) The Tax-Free Savings Account (TFSA) is a flexible, registered, general-purpose savings vehicle that allows Canadians to earn tax-free investment income to more easily meet lifetime savings needs. The TFSA complements existing registered savings plans like the Registered Retirement Savings Plans (RRSP) and the Registered Education Savings Plans (RESP). How the Tax-Free Savings Account Works As of January 1, 2013, Canadian residents, age 18 and older, can contribute up to $5,500 annually to a TFSA. This is an increase from the annual contribution limit of $5,000 for 2009 through 2012 and reflects indexation to inflation. Investment income earned in a TFSA is tax-free. Withdrawals from a TFSA are tax-free. Unused TFSA contribution room is carried forward and accumulates in future years. Full amount of withdrawals can be put back into the TFSA in future years. Recontributing in the same year may result in an over-contribution amount which would be subject to a penalty tax. Choose from a wide range of investment options such as mutual funds, Guaranteed Investment Certificates (GICs) and bonds. Contributions are not tax-deductible. Neither income earned within a TFSA nor withdrawals from it affect eligibility for federal income-tested benefits and credits, such as Old Age Security, the Guaranteed Income Supplement, and the Canada Child Tax Benefit. Funds can be given to a spouse or common-law partner for them to invest in their TFSA. TFSA assets can generally be transferred to a spouse or common-law partner upon death. Using a Leveraged Insured Retirement Program (IRP) to fund retirement This strategy involves purchasing a participating whole life (PAR) or universal life (UL) insurance policy generally a minimum of years prior to retirement. Policies that qualify as exempt under the ITA (all PAR and most UL policies issued in Canada qualify), allow funds to accumulate inside the policy on a tax-sheltered basis by virtue of sections 148 and 12.2 of the ITA. In a UL policy the other component of the policy is the life insurance component. It is separate from the investment, but both form part of the same life insurance policy. What makes universal life insurance attractive is premium flexibility. A client can deposit more or less into the plan, as long as there is enough to cover the premiums for the life insurance component. While PAR policies also have a level of premium flexibility we cannot separate the life insurance from the investment component. In UL contracts the excess contributions (up to a maximum limit calculated with reference to ITA rules) form part of the investment account in the policy that can grow on a tax-sheltered basis. Upon the death of the insured, the total death benefit is paid out tax-free to the beneficiary(ies). This applies whether the contract is PAR or UL. Tax may be payable if the policy is disposed of and the investment funds withdrawn, in whole or in part, before the death of the life insured. Three ways to access the investment accounts in retirement: 1. Withdrawals from the policy 2. Policy loans from the insurance company 3. Collateralization with a financial institution THREE WAYS TO ACCESS INVESTMENT ACCOUNTS IN RETIREMENT Withdrawal from the policy Withdrawals can be taken directly from the life insurance policy s cash surrender value. When a partial withdrawal is taken, the adjusted cost basis (ACB) may have an impact on the net amount withdrawn as the difference between the amount withdrawn and the ACB is taxable. The amount of the ACB is proportional to the total amount withdrawn. Policy loans Funds can also be accessed as a policy loan. In essence, these are not typical loans, but rather advance payments of the policyholder s entitlement under the policy. The advances do not have to be repaid to the insurer. A policy loan constitutes a disposition for tax purposes and will attract taxation when the total loan amount exceeds the adjusted cost basis of the policy. The insurance company will charge interest on any outstanding balance of policy loan. Any outstanding loan balance will be deducted from the policy proceeds at death with the net amount then being paid to the beneficiary(ies). 3
4 Collateralization with a financial institution Another way to access the account value of the life insurance policy is by pledging the policy as collateral for a loan or series of loans from a financial institution. At retirement, the policy may be used as collateral security, and the financial institution will grant yearly loans or a lump sum, which can provide an additional source of yearly income to meet needs in retirement. Based on current tax rules (as at December 31, 2012) the loan proceeds are not taxable. THE IRP CONCEPT COLLATERALIZATION The IRP concept uses the collateralization method to access the account value in the policy and operates as follows: The individual purchases a universal life policy or a participating whole life policy on his/her own life (or jointly with spouse). The individual makes deposits (subject to certain limits under the ITA) into the contract Income accumulating in the contract is tax-sheltered unless it is withdrawn from the policy or exceeds maximum allowable limit under the ITA. When the individual retires and desires additional funds, the life insurance policy can be used as collateral to obtain a loan, or a series of loans, from a financial institution. The financial institution will lend up to a specified percentage of the cash surrender value of the policy. This percentage varies depending on the type of investment account. Loan amounts can be received as periodic payments or as a lump sum. Based on current legislation, loan proceeds are tax-free. The loan is repaid when death proceeds are payable from the policy, unless loan repayment is demanded earlier. The residual balance of the death benefit, if any, goes to the deceased s other beneficiaries. There are two ways in which the loan arrangement can generate cash for the retiree: 1. Borrow a lump sum and purchase an annuity The maximum amount allowable based on the policy cash value is borrowed as a lump sum and used to purchase an annuity. This is not the most effective method. While the loan itself is tax-free, a part of the annuity income is subject to income tax every year. In addition to the income tax due, the loan interest owing must be addressed. There are two options: the interest can be paid each year if the borrower so chooses or, the interest on the loan could be capitalized each year. If the interest is capitalized, the financial institution will advance an amount equal to the interest due and use this amount to pay the interest. The net effect is that the loan increases each year by the interest amount. The initial loan amount will be set lower, so that the projected loan plus capitalized interest over the life expectancy of the borrower will not exceed the financial institution s maximum lending ratio based on the projected cash value of the policy over the same period. 2. Receive a series of loans A more effective method is to arrange a series of annual loans. The interest on the first loan will be capitalized (if the borrower wishes). The second loan will be added to the first, including capitalized interest and so on. The total loan at any time will be the sum of the annual loan amounts to date plus all of the capitalized interest. The annual loan amount will be set such that at the life expectancy of the borrower, the sum of all of the annual loans plus capitalized interest will not exceed the financial institution s lending ratio based on projected cash value and the type of investment account. The attraction of the second approach is that no income tax will be payable, since all monies are received in the form of loans which are not subject to income tax. HOW MUCH WILL THE FINANCIAL INSTITUTION LEND AGAINST THE POLICY? The loan is secured by the policy cash value. If the funds within the policy are invested in guaranteed fixed income accounts, the financial institution will generally allow loans plus capitalized interest (if this has been elected) to accumulate to 75% to 90% of the cash value in the policy. If the funds are invested in variable accounts, such as managed accounts, the financial institution may only lend up to 50% to 60% of their value. WHO SHOULD CONSIDER THE IRP STRATEGY? This strategy is most suited to the following individuals: An individual who has maximized contributions to (or pension benefits receivable from) employer-sponsored pension plans and RRSPs and has excess cash to invest for retirement. An individual who will need higher income in retirement than can be provided through a combination of government and private taxassisted pension and RRSP plans. An individual who has a minimum of 15 years to accumulate additional funds before he/she will need to access the funds. An individual who is comfortable with borrowing strategies and understands the risks associated with them. Younger people who take a long-term planning perspective and can make deposits over and above the RRSP or Pension (RPP) maximums can take advantage of: Owning a permanent, exempt policy rather than a temporary policy. Accumulating assets in excess of the RRSP/RPP limits in an exempt policy rather than in a non-registered vehicle. Benefits of the IRP option. Since the funds inside the policy grow on a tax-sheltered basis, it is possible to outperform traditional non-registered savings vehicles that are subject to annual taxation and therefore provide a larger after-tax source of cash flow (with the policy structured for investment purposes it is possible to minimize the face amount of the insurance thereby minimizing and ultimately eliminating its cost). 4
5 The loan proceeds are tax-free under current legislation. Since the loan proceeds are not deemed to be income, no clawback of government benefits would be triggered by the transaction. The portion of the life insurance proceeds remaining after the loan balance is repaid is available for beneficiaries. The individual can control how much to borrow against the policy based on his/her needs. Neither the registered nor the nonregistered plans can take advantage of the loan approach. In the case of registered plans, ITA and pension rules dictate the manner and timing of withdrawals from the plan. Once withdrawn, the income is taxable. FACTORS AND RISKS TO CONSIDER Beneficiary designations In the Common Law provinces, if the policy owner has designated a preferred beneficiary (spouse, child, grandchild, parent of the insured) or an irrevocable beneficiary, the policy is generally creditor protected. In Quebec, the rule is different. The policy is generally creditor protected if the policy owner has designated a preferred beneficiary (his spouse, his descendants, his ascendants) or an irrevocable beneficiary. However, we should note that when a beneficiary has been designated to be irrevocable*, the owner s freedom is limited with regards to the policy. Any change that could materially affect the benefit must have the consent of an irrevocable beneficiary. Thus, any pledge of the policy as security for a loan will need the signature of that beneficiary. In situations where the insured and beneficiary are estranged, an agreement may not be forthcoming. Reduction of death benefit The IRP arrangement reduces the death benefit available to heirs. Taking a loan against the policy may deprive a beneficiary of needed cash after the death of the insured because part of the death benefit must be used to pay off the loan. Even if additional funds are required during the insured s lifetime, the impact of a reduced death benefit should be factored into the decision to proceed with leveraging. In situations where a single life, zero guarantee annuity has been recommended as another component of retirement income planning, the life insurance death benefit is expected to be there to provide an income for the surviving spouse. If part of the death benefit is needed to pay off a loan, only a portion will remain, which may not be sufficient. Compounding effect of loan In a case where the interest is capitalized, the loan will increase each year by the amount of the interest. If the loan is in effect for a long period of time, the compounding effect of these additions may cause the loan amount to exceed the financial institution s lending ratio based on the policy cash value and the financial institution may call the loan. Therefore, use of this loan arrangement should be restricted to applications where there is a natural limit to the likely duration of the loan. Use of the arrangement at retirement is ideal because life expectancy will tend to limit the loan duration. Since the ultimate intent is to repay the loan from the policy death benefit, the arrangement would not be appropriate if a person aged 40 or 50 were to start a series of loans today. Financial institution calls the loan If the loan were to exceed the maximum allowable percentage of the cash value, the financial institution could call the loan. If the financial institution recalls the loan, the life policy would be surrendered resulting in the loss of the tax-free death benefit and the triggering of tax on the accumulated gain. This possibility should be averted at all costs. It is especially important to note that any income tax liability arising out of a forced policy surrender is a liability for the policy owner, not the financial institution. The risk of the loan exceeding the cash value arises from three sources: 1. An increase in the spread between the interest rate charged on the loan and the interest being earned within the policy. 2. The time over which the loan is growing is longer than anticipated. 3. The cost of insurance has a negative impact on the growth of the account. Investment risk There are risks associated with any type of investment. When debt is also incurred, additional factors must be considered. The maximum loan amount will depend on the investments held in the policy account. Financial institutions, currently, will generally loan up to 75% to 90% of the value of fixed income investments but only up to 50% to 60% of equity-linked investments. At the time of borrowing, the investment mix may need to be amended to maximize the amount that may be collateralized. Since the loan is generally a variable rate loan, the interest rate can increase without a corresponding increase in the return on the investments. Higher interest charges, if not paid yearly, can cause the outstanding loan balance to increase more rapidly and thus reducing future loan capacity. If the return on investments also drops, the fund and the maximum loan amount are also reduced. The outstanding loan and the policy account need to be monitored frequently to avoid a situation where the loan exceeds the financial institution s ratio and forces a reduction in the loan through capital repayments or a collapse of the life policy to repay the debt. Changes in financial institution policy or tax rules Currently financial institutions make no commitment that they will continue to offer these types of loans in the future. Lending rules can change and may make this type of loan unavailable. As well, upon renewal, the financial institution may wish to change the terms of the loan. In addition, should the treatment of these loans by the tax authorities change, this arrangement could be rendered much less attractive. * In common law provinces (all provinces except Quebec), a spouse, child, grandchild, mother or father designated as a beneficiary before July 1, 1962 will also have to give consent if the contract is to be leveraged. 5
6 USING A CORPORATION TO OWN AND LEVERAGE THE LIFE INSURANCE POLICY There are situations where a corporation is the owner of the life insurance policy on the life of one of its shareholders. The corporation may want to leverage the policy and use the loan proceeds to redeem the shareholder s shares as part of a retirement strategy. There could, however, be negative tax consequences if the loan proceeds are forwarded to a shareholder or employee directly, for the purpose of supplementing retirement cash flow. In general, loans to shareholders will be included in the shareholder s income without a corresponding deduction to the corporation pursuant to subsection 15(2) of the ITA. The only way to avoid this result is for the shareholder to repay the loan within 1 year of the end of the taxation year in which the loan was made. (Note: there cannot be a series of loans and repayments). The same rule applies to employees unless the employee (and related family members) own less than 10% of any class of shares of the business. If the employee fits within the exception, the loan will not be included in income but an imputed interest benefit will be included. If the business redeems shares or distributes the loan proceeds by way of dividend to the shareholder, they will be considered taxable dividends in the hands of the shareholder. (assuming that the corporation does not have a balance in its Capital Dividend Account (CDA) and thus cannot declare a Capital Dividend) Retirement Compensation Arrangement (RCA) Rules Where a corporation acquires a life insurance policy with a view to providing retirement benefits, the policy may be deemed to be an RCA pursuant to subsection 207.6(2) of the ITA, and specific tax rules will apply. This would have negative tax implications. The following rules would apply: 1. The employer/corporation would be required to withhold and remit a tax equal to the amount of the insurance premium to a refundable tax account with Canada Revenue Agency (CRA). 2. The employer would receive a tax deduction for twice the amount of the insurance premium. 3. Refunds from the refundable tax account would be included in the income of the recipient. 4. The full amount of the death benefit that is received by the employer would be taxable to the employer as a distribution from the RCA. DEDUCTIBILITY FOR TAX PURPOSES Deductibility for tax purposes of interest incurred on a loan The general rule is that interest is only deductible for tax purposes when it is paid or payable pursuant to a legal obligation to pay, and when the proceeds of the loan are used for the purpose of earning income from a business or property (paragraph 20(1)(c) of the ITA). With the IRP strategy, where an individual leverages the policy and the loan proceeds are used for personal living expenses, the interest would not be deductible since the borrowed funds are not used to gain or produce income. In cases where a business leverages the life insurance policy, one must look at the facts on a case-by-case basis to determine if interest will be deductible. On October 31, 2003, the Department of Finance introduced proposals relating to interest deductibility. If a deduction is to be sought for the interest paid on any borrowings, the borrower should consult their tax advisor as to the impact of these proposed rules. Deductibility for tax purposes of life insurance annual premiums A policyholder may be able to deduct all or a portion of the life insurance premiums where the policy is used as collateral, provided that the policy is assigned to a restricted financial institution, the interest incurred on the loan is deductible, and the restricted financial institution requires the policy as collateral. The amount deductible is to be capped at the lesser of the premiums payable in respect of the year, and the Net Cost of Pure Insurance (NCPI) for that year. It will also need to be related to the amount owed versus the life insurance coverage amount. GENERAL ANTI-AVOIDANCE RULE (GAAR) Subsection 245(2) of the ITA contains a provision called the General Anti- Avoidance Rule (GAAR). The provision allows CRA to re-characterize a transaction if the transaction is a misuse or abuse of the provisions of the Act. If CRA applied GAAR to leveraged insurance transactions, it might attempt to re-characterize the loan from the financial institution as a policy loan. If it is deemed to be a policy loan, amounts in excess of the policy s adjusted cost basis would be taxable. It is arguable that GAAR should not apply to recharacterize the loan. One argument is that a policy loan is defined in the Act to be an amount advanced by an insurer in accordance with the terms of the policy. Since the insurer is not advancing the funds in accordance with the terms of the policy, the transaction should not fit within the definition of policy loan. CONCLUSION As with any investment option, it is important to review both the risks and rewards. In the right situation, an IRP can provide additional cash flow in retirement and provide ermanent life insurance for the individual s beneficiaries. 6
7 This document is intended for general information only. It should not be construed as legal, accounting, tax or specific investment advice. Clients should consult a professional broker concerning their situations and any specific investment matters. While reasonable steps have been taken to ensure that this information was accurate as of the date hereof, The Financial Horizons Group and its affiliates make no representation or warranty as to the accuracy of this information and assume no responsibility for reliance upon it.
8 ONTARIO / ATLANTIC DIVISION KITCHENER (Head Office) BARRIE BURLINGTON DARTMOUTH KINGSTON OTTAWA PEEL PETERBOROUGH SOUTHWESTERN ONTARIO ST. CATHARINES SUDBURY TORONTO QUEBEC DIVISION EASTERN Quebec City Trois-Rivières National Head Office Ontario/Atlantic Division 22 Frederick Street, Suite 112 Kitchener, Ontario N2H 6M6 tel toll free fax Quebec Division 2851 King Street West Sherbrooke, Quebec J1L 1C6 tel toll free fax Western Division 62 Hargrave Street, Suite 208 Winnipeg, Manitoba R3C 1N1 tel toll free fax WESTERN Brossard Gatineau Montréal Saint-Laurent SOUTHERN Sherbrooke WESTERN DIVISION CALGARY EDMONTON WINNIPEG FIN0008-L-V