The life insurance industry has long been at the forefront of innovative tax planning strategies. For the most part, these plans are designed with the help of special rules that exempt from tax the accumulating income of funds invested within a policy. Also, the proceeds paid to beneficiaries upon the death of the policyholder are free of tax.
One of the more interesting strategies is the “back to back prescribed annuity”. This plan is best described through an example. Suppose Mr. Lime has $1 million invested in term deposits yielding a conservative rate of interest, and wishes to enhance his return. He could use his capital to purchase a prescribed annuity. A prescribed annuity is a plan which pays a certain fixed rate of return to the investor over the remainder of his life. Payments are made up of a combination of interest and a return of capital. Taxes are paid by the individual based on amounts received each year, and the capital portion is not included in taxable income. As a result, the tax burden attached to the annual income stream is reduced.
If Mr. Lime purchases the annuity, his capital can no longer be accessed. However, he would use part of the annuity payments to purchase a life insurance policy which would pay $1 million to his heirs upon his death. His original capital, therefore, is guaranteed for the next generation.
Clearly, this strategy is not for everyone. It would be recommended where the investor is of retirement age, in good health, and is otherwise holding conservative investments. He must be willing to part with a portion of capital which would be preserved for his heirs. Finally, if interest rates are low, this plan might not be very attractive since the annuity is locked in for life, with no chance of cashing in to reinvest in a higher-yield security.
One of the more attractive offshoots of the above strategy is where the investment is held in a holding company, say Limeco. Upon the death of an individual, the tax rules provide that he is deemed to have disposed of all his capital property for proceeds equal to fair market value immediately prior to the date of death. For this purpose, the value of a life insurance policy or a life annuity is equal to its cash surrender value, not the value of benefits paid on death.
In the above example, if the investments were held in a corporation, the purchase of an annuity by Limeco would reduce the value of the shares of Limeco by $1 million. Furthermore, the death benefit received by Limeco would not form part of his deemed proceeds. The amount exceeding the adjusted cost base of the policy could be paid out to the estate on a tax-free basis through the capital dividend account.
Although they can be complex, strategies involving life insurance must be considered for high-net worth individuals looking to enhance after-tax returns.