What is a family wealth transfer plan?
The wealth transfer strategy is a tax-savings and wealth preservation approach that uses insurance to move wealth to subsequent generations while reducing overall family income taxes. The strategy uses life insurance, but the transfer is made during your lifetime.
How does it work?
This approach uses permanent life insurance to tax-efficiently transfer wealth. If you have accumulated more wealth than you will require in your lifetime and have maximized RRSPs, TFSAs and other savings vehicles, you can use this strategy to preserve and transfer wealth. It works like this: using excess non-registered funds, you purchase a permanent life insurance policy to cover a child or grandchild of any age (see points below for the definition of “child”). You own the policy and overpay the premiums for a number of years to create cash value.
Later, as long as the child is over age 16 (18 in Quebec), you will transfer the ownership of the insurance policy to the child or grandchild whose life it covers, or to another child/grandchild (for example, the policy could be on your grandchild’s life and you could transfer the policy to your adult child). Now that they own the policy, your child or grandchild has access to the excess cash value that you paid into the policy, which they could use for major life expenses such as buying a home. If it’s necessary to transfer the policy to the child before they are 16, a trustee must be appointed to manage the policy.
The insurance policy still offers the normal tax-free protection you get with a life insurance policy, and if the policy is purchased on a young child, locks in insurability if the child chooses to keep the policy in force. In addition, investment growth within the policy is tax-sheltered, thus reducing your taxes. Transferring wealth through insurance also reduces probate costs. Withdrawals of the cash value will be taxed in your child’s hands as long as the child is over age 18 when they withdraw. Most likely, they will pay tax at a lower rate than you would have on those funds.
The policy could qualify for a tax-free rollover, thus reducing overall taxes on the funds you paid into the policy.
Qualifying for tax-free rollover
There are requirements under the Income Tax Act. To qualify as a tax-free rollover,
- The life insurance policy must be on the life of an individual child or grandchild – a policy on your own life will not qualify. However, a joint-last-to-die policy on you and a child would qualify as long as only one person is covered at the time of transfer.
- The transfer must be made to a child, step-child, grand- or great-grandchild, step-grandchild, or another minor wholly dependent on the person who initially purchased the policy (i.e., a ward); the child can be a minor or an adult.
- The transfer must be for no consideration (i.e., for free).
- The transfer must be directly to the child – transfers to a trust will not qualify, even if the child is a beneficiary of the trust.
- The transfer of policy ownership through your will does not qualify.
Because the policy is transferred without consideration, the child who receives it is deemed to have received it at a cost equal to your adjusted cost basis, so there are no tax consequences.
Name a successor
It’s important to name a successor owner of the policy so that the policy does not enter your estate and become a taxable disposition if you happen to pass away before you transfer the policy. If you name your child as a successor owner, if you die, the transfer of ownership of the policy will qualify as a tax-free rollover if the other requirements are met. Another scenario sees the policy purchased on the life of your grandchild, with the grandchild’s parent – your child – named as the successor owner. If you wish to retain control of the policy even after the transfer, you can place an irrevocable beneficiary on the policy before you transfer it.
The family wealth transfer strategy can be complex, especially in cases where step-children are involved and/or if the step-child’s natural parent has passed away or the parent/step-parent relationship has ended. So if you are considering employing this approach, talk with your insurance advisor and/or estate planning expert to make sure you meet the requirements and manage the strategy to best advantage.
