Overview of 2017 tax changes affecting life insurance
The current legislation governing the tax treatment of life insurance policies was created in the 1980’s. Since then new generations of products, particularly Permanent universal life products (UL), have added features that the original legislation did not contemplate. The Department of Finance has been working with the insurance industry over many years to update the legislation. The new legislation will affect life insurance policies issued after December 31, 2016.
Policies issued on or before December 31, 2016 are considered to be grandfathered. Thus, policies issued January 1, 2017 and after will lose their grandfathered status and the new legislation will apply.
To better understand the tax rules for life insurance policies, a policy can be viewed in three components: deposits and savings which affect payout.
Premiums are deposited into an insurance policy. These premiums are used to cover current mortality and expenses.
The savings component is the remainder of the premium after mortality coverage and expenses. It is accumulated with interest to pay future benefits.
There are two ways one can get a payout from a life insurance policy: from a death benefit and/or through withdrawal (surrenders or loans).
The following elements within each component are affected by the changes to the legislation.
Savings component impact
Investment earnings help to grow the savings within a life insurance policy. When held within a life insurance policy, these investment earning have the advantage of not being subject to tax as long as the savings component is less than certain limits. This is referred to as an exempt policy. The amount of savings in an insurance policy is limited by the savings component of a hypothetical policy prescribed by the legislation called the Exempt Test Policy (ETP). The new legislation changes how to calculate the savings components of both the policy and the ETP such that a policyholder will be allowed to save less inside their insurance policy.
The 250% Rule
The 250% rule was introduced to discourage, and thereby limit, large deposits (dump-ins) in the later years of a policy. The 250% Rule works as follows. Starting in year 10 of a policy, the insurer tests to ensure that the cash value is not greater than 250% of the cash value three years prior. In other words, the test in year 10 will look at the cash value of the policy in year seven. If a policy failed and the cash value was greater than 250% of the cash value three years prior, it would have significantly reduced the sheltering room in a policy for additional deposits. The new legislation actually relaxes the rules for both new business and in-force policies such that it will be more difficult to fail the 250% Test. Further, if a policy fails, it is given time to readjust itself before testing starts again. The net result is that the relaxation of the rules could result in additional deposits into policies in the later years of the policy.
Payout component impact
Adjusted cost basis (ACB)
The ACB is the adjusted cost basis of a life insurance policy. It is used to determine the taxable gain upon withdrawal from a policy and to calculate the credit to the capital dividend account (CDA) of a private corporation upon death of the insured. The new legislation changes a few elements and adds new elements to the ACB
Net cost of pure insurance (NCPI)
Generally, the ACB of a policy is increased by the premiums paid and reduced by the cost of insurance, referred to as the Net Cost of Pure Insurance (NCPI). The changes to the legislation result in a reduction in NCPI. Generally speaking, this will result in a higher ACB which will be beneficial for policyholders who surrendered their policies. The reduction in NCPI may also result in a lower tax deduction for life insurance policies assigned as collateral for a loan.
Currently the calculation of the ACB does not include the effect of substandard ratings. After December 31, 2016, the ACB calculation will include the effect of substandard ratings. This means the ACB for life insureds who are rated will be higher in the initial years but will be decreased in the later years.
Fund value (FV) payout on multi-life UL policies
A multi-life UL policy provides insurance coverage to different life insureds under one policy. Currently these policies will payout the full fund value on the death of any of the insureds tax-free and without reduction to the ACB of the policy. The new legislation limits the tax-free fund value payout to the amount of the fund value had the deceased insured originally had a single life insurance policy. Further, the tax free fund value payout will reduce the ACB, therefore, any subsequent fund value payout from the multi-life policy could result in a tax liability.
To summarize, the impact of the new legislation on life insurance policies may result in the following changes:
- A lower amount that can be saved inside a UL policy on a tax-advantaged basis:
- A relaxed 250% rule that will result in less failures of this test and may encourage more deposit at later durations.
- A reduction in the NCPI. This will mean a higher ACB with less taxable gains for withdrawal from a policy, but lower tax deductions for collateral loans. Also a lower amount can flow to a private corporation’s CDA.
- Substandard ratings will increase ACB initially but will decrease in the later years.
- Fund value payout on multi-life policies will lose much of its tax advantages
The new legislation will not apply to policies issued on or before December 31, 2016, meaning the policies are grandfathered, unless certain changes are made after December 31, 2016
Note: These changes include term conversions after December 31, 2016 to a permanent product and changes that require medical underwriting (exceptions include, but are not limited to, reduction of ratings, changes from smokers to non-smokers, and reinstatements).
More about Grandfathering
Existing policies already in place will be grandfathered, so long as certain policy changes are not made on or after January 1, 2017.