In working with affluent families, one of the key questions I commonly hear is how to transfer wealth to their children and/or grandchildren while paying the least amount of tax?
Here is a strategy that allows for wealth to accumulate on a tax-sheltered basis and effectively transfer to children and/or grandchildren free of income tax and probate fees. Specifically, the concept is known as “Cascading Insurance” or “Waterfall Insurance”.
Life Insurance as a Wealth Transfer Tool
Firstly, it is important to understand that permanent life insurance (e.g., Whole Life or Universal Life insurance) is provided certain favourable attributes under our tax laws.
Every dollar of insurance premiums paid on a permanent policy is split so that some of the premium covers the pure cost of the insurance on the insured’s life and the remaining portion of the premium goes into a tax-sheltered pool of investments – a.k.a., the “accumulating fund”. Premiums can grow inside the policy on a tax-sheltered basis. On the life insured’s death, the Death Benefit is paid tax-free to the ultimate beneficiary.
With respect to Cascading Life Insurance, there are very advantageous tax rules which allow for the transfer of ownership of a life insurance policy to one’s “child” on a “rollover” / tax-free basis. For purposes of these rollover provisions, a “child” includes a natural or adopted child, a grandchild, a stepchild, or a son or daughter-in-law.
Who is this Strategy Suitable for?
Typically, we have implemented this strategy for our clients that have more than sufficient wealth to fund their own lifestyle needs and have a desire to gift wealth to their children during their lifetimes.
How it Works?
A grandparent (“Generation 1”) typically purchases a whole life insurance policy and makes a deposit into it over 5-10 years, for example. The grandparent is the policy owner. However, the grandparent names an adult child (“Generation 2”) as the contingent owner and the policy is actually placed on that person’s life (i.e., the life insured is the adult child, Generation 2). Lastly, the grandchild (“Generation 3”) is the beneficiary of the policy.
Once the grandparent passes away, the adult child (Generation 2) becomes the policy owner and has access to the investments that have accumulated inside the policy on a tax-sheltered basis. Due to the inter-generational rollover rules, the policy ownership transfers completely tax-free from Generation 1 to Generation 2.
The adult child may then access / withdraw funds from the policy’s cash value or simply hold the policy for the grandchild’s benefit – who will receive the death benefit (free of income and probate tax) upon the adult parent’s death.
It should also be noted that the grandparent (Generation 1) may transfer the policy to the adult child (Generation 2) while they are alive in order that the child may access the policy’s cash – e.g., for Generation 2 to meet their own cash needs – such as paying for post-secondary education, purchasing a home, etc.
Moreover, by utilizing this strategy at an early age, Generation 2 is afforded insurance to provide their own piece of mind and estate protection for their family by having locked-in favourable coverage at an early age – as insurance becomes more expensive to obtain as one ages and health declines.
Key Benefits of Cascading Insurance
This strategy offers some of the following key benefits:
- Life insurance protection on the life of your child or grandchild;
- Tax-sheltered growth of wealth;
- Tax-free death benefit at the life insured’s death;
- Ability to transfer policy ownership to your child or grandchild (during life or at death) on a tax-free “rollover” basis; and
- After the policy has been transferred, your child (i.e., the new policy owner) can access the cash value, as required
Takeaway
The Cascading Life Insurance Strategy involves using permanent life insurance to provide protection on a child or grandchild while also acting as a tax-efficient vehicle to enhance and transfer wealth to the next generation. This is one of the many tools we consider when looking at strategies to transfer wealth in the most tax-efficient basis and help our clients in achieving their legacy goals.
