The article “Should you buy life insurance to pay for tax owed upon death?” was originally published in MoneySense on April 1, 2024. Photo by charliepix from charliepix.
When you die, capital gains tax might apply to some of your assets. Can life insurance help shelter your beneficiaries from taxes owed?
Ask MoneySense
I’m of retirement age and have some soft and hard assets, which—if redeemed, sold or when I pass away—will incur capital gains. My children will have to come up with funds to pay. So, my question is, how can I best prepare hereon to either minimize such tax or to shield against the impact of such tax? For example, just a haphazard thought, should I buy more insurance so that such insurance can possibly help my children to pay the capital gains tax? —Nazim
Who pays tax upon your death?
When you die, you are deemed to sell all of your assets. There is a so-called deemed disposition based on the value on the date of your death. Some assets, like those left to your spouse or common-law partner, may avoid this tax event. When you leave assets to your surviving spouse, they can generally be transferred to them at your cost base with no tax payable.
Capital gains tax, Nazim, might apply to some of your assets. If you own non-registered stocks or a rental property, for example, they might be subject to a capital gain on your death. Your home would likely be sheltered by the principal residence exemption. A tax-free savings account (TFSA) is tax free, whereas a registered retirement savings plan (RRSP) is not subject to capital gains tax, but is subject to regular income tax. Your RRSP, unless left to a spouse, is generally fully taxable on top of your other income in the year of your death.
The tax is payable by your estate, so although it reduces the inheritance left to your beneficiaries, it’s not payable directly by them. It can be paid with the assets that make up your estate.
Hard versus soft assets
You mention that your estate is made up of hard and soft assets, Nazim. I assume by hard assets you mean real estate. And by soft assets you mean cash, stocks, bonds, mutual funds and/or exchange-traded funds (ETFs).
Your soft assets can be very liquid and used to pay the tax that your estate owes. That tax is not due until April 30 of the year following when your executor files your final tax return. If you die between November 1 and December 31, there is an extension to six months after your death for your executor to file your tax return and pay the tax owing. So, there’s always at least six months to come up with the funds required to pay income tax on death, and there’s more than six months when a death occurs between January 1 and October 31.
Since soft assets are considered sold upon death, there is generally no advantage for your beneficiaries to keep those assets rather than turn them into cash or into other investments of their choosing.
Your hard assets, Nazim, are obviously less liquid. If there is a special property, like a family cottage or a rental property, they choose to keep, I can appreciate how you might want to make sure they can do that without being forced to sell.
Should you buy insurance to cover tax owed upon death?
Your cash and investments may provide sufficient funds to pay taxes owed upon death. Or your beneficiaries may choose to sell one or more of your real estate properties. You could buy life insurance to pay the tax, but I find this strategy is oversold or misunderstood. I will explain with an example.
Let’s say you are 62 years old, and your life expectancy is another 25 years, based on your current health. If you buy a life insurance policy that requires a level premium of $5,000 per year for life, and you pay that premium for 25 years, you will have paid $125,000 to the insurance company. If you instead invested the same amount each year at a 4% after-tax rate of return, you would have accumulated $216,559 after 25 years.
Now, the insurance company invests the money you pay in premiums. It does not have a magical way to earn a 20% rate of return each year. So, chances are your life insurance policy’s death benefit would be similar to the amount of money you could have accumulated on your own—maybe $200,000 to $225,000, as in the example above. It will not be $1,000,000 or some extraordinary amount.
So, if you have the extra cash or cash flow necessary to pay the premiums for the rest of your life, you could always save and invest that money on your own instead. You may end up in the same position—or maybe a better position if you have a moderate or high risk tolerance and if your investment fees are low.
When do you need life insurance?
By no means am I saying to ignore life insurance and invest on your own in all cases. If you are working and have dependents, you should have life insurance as a risk-mitigation strategy. If you have a corporation and lots of money you’re unlikely to spend during your own life, life insurance could be used as a tax-reduction strategy to get the corporate value of your corporation to your beneficiaries. But buying a life insurance policy to pay tax might not always be the best approach.
One exception could be if you were young, working and saving money, and owned a business with a large deferred-tax liability. If your family would be forced to sell the business at a fire-sale price to pay the tax, you might want life insurance. But, if you are approaching retirement and thinking about buying life insurance to pay the tax on your RRSP or rental property, I suggest to think twice.
Discuss the options with your beneficiaries
One final point, Nazim, is that parents may assume their kids want to keep a cottage or rental property or even their home after they die. In reality, they may decide to sell and pay down debt, contribute to their RRSP and TFSA accounts, or do something they want with the money now that it is theirs. An open dialogue with your kids may influence your own planning for the future. What you think they want may be different from what they actually want.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.
