Can life insurance fund RRSP estate tax erosion?

When planning your estate. It is important to consider how taxation will affect the future distribution of your estate.  For individuals who are married, when the first spouse passes away, the assets can generally be rolled over tax-free to the surviving spouse. However, when the last surviving spouse passes away, all assets are deemed to have been sold at the time of passing, and this includes your Registered Retirement Savings Plan (RRSP) or Registered Retirement Income Fund (RRIF) holdings. 

Concerns about leaving wealth to the next generation. Registered assets are taken into income in the year of the surviving spouse’s death, and taxes must be paid.  These taxes will be due after the death of the second spouse, where there are no dependent children. An eligible individual is a child or grandchild of a deceased annuitant under an RRSP or RRIF, or of a deceased member of a Registered Pension Plan (RPP) or a Specified Pension Plan (SPP) or Pooled Registered Pension Plan (PRPP), who was financially dependent on the deceased for support, at the time of the deceased’s death, because of an impairment in physical or mental functions. The eligible individual must also be the beneficiary under the Registered Disability Savings Plan (RDSP), into which the eligible proceeds will be paid. ¹

Without an eligible dependent, a $500,000 RRSP or RRIF could be reduced to about half the sum after the death of the second spouse (assuming the highest tax rate).  How can this be avoided? How can you leave more of your wealth to the next generations?

A joint last-to-die life insurance policy may be a solution. A joint last-to-die policy insures two lives, usually two spouses, for the purpose of paying for an estate’s tax liabilities, such as capital gains on a cottage or business. In most cases where there also exists significant family wealth in RRSPs or RRIFs, taxes will eventually be due upon the second spouse’s death.  At that time, the entire remaining RRSP or RRIF funds are brought into income. Though this is not creating a liability as such, the taxation of large holdings of registered monies can deplete a family’s overall wealth.

By purchasing a joint last-to-die life insurance policy, the taxation of assets in a family’s estate plan can be offset by the significant life insurance proceeds.² In the above example, a joint last-to-die life insurance policy for $250,000 would replace the estate value lost to taxation, therefore helping to preserve the estate’s net worth more fully for the family. This is especially true if the RRSP or RRIF owner expects to leave the entire amount to their heirs.

What about the life insurance premiums?  The premium for the life insurance policy to pay for the estate’s tax loss through RRSP or RRIF final estate taxation is usually a small percentage of a significant registered investment portfolio compared to the much larger tax bite. The death benefit may be partially tax-free. ² A joint last-to-die policy can also be structured to reimburse all premiums paid into the policy, thereby minimizing the cost to the estate for a strategy designed to save money.

¹ RDSP – Canada.ca

² Note: It is recommended that you get qualified tax advice concerning the taxation of your registered retirement plans if you consider this strategy.