Second-to-Die Insurance Covers Tax Liability

Second-to-Die Insurance Covers Tax Liability

When doing family estate planning, there are often large future income tax obligations to provide for. These can be deferred fairly easily when one spouse dies but cannot be avoided, and must be paid quickly on the death of the surviving spouse. Two situations where this often arises on death involve the unrealized capital gains on family property and assets and the balance of funds remaining in RRSPs and RRIFs.

This tax issue may occur, for example, when parents express a desire for assets such as a family business or property investment, or personal property – a cottage or chalet – to remain in the family after their death. If the assets in question have been held for a number of years and have increased in value over this time, there will be deemed realization of their fair market value for capital gains tax purposes when they pass to the next generation.

Currently, 50% of  capital gains will be included in taxable income on the deceased's final tax returns.

Upon death, tax can be deferred by leaving the deceased's interest in the property to his or her spouse, either outright or in a spousal trust established under their will. Generally, this requires the survivor to be given any income interest generated by the property during survivorship, but no remainder or capital interest must be given unless it's claimed by the other spouse. On the death of the second spouse, the taxable capital gain is calculated based on fair market value at that time.

Thus, tax can be deferred during the survivorship of the second spouse, but it's then calculated based on the fair market value of assets at the end of that further period — and if the value of the assets concerned has increased in the meantime, the tax will rise accordingly.

Similar tax deferrals can be arranged by leaving balances remaining in RRSP and RRIF accounts to the surviving spouse, preferably by naming them as beneficiary in the RRSP or RRIF documentation itself. If it's left up to the decedent's will to pass RRSP or RRIF balances to the surviving spouse, the proceeds must be probated at some considerable cost. If RRSP or RRIF balances are left to a spouse in either manner, regular tax on the funds can be deferred until they're drawn by the surviving spouse or until they die. If the balance of funds in RRSP or RRIF accounts are left to children or other beneficiaries, they're fully taxable at regular tax rates. This means remaining RRSP or RRIF funds are ordinarily fully taxable at regular tax rates on the death of the second spouse.

In some estate situations there's sufficient cash or other liquidity in the estate to meet tax obligations. This is more likely in an estate consisting of marketable securities or other liquid investments that can be readily sold and the proceeds used to pay tax. But other estates involve different circumstances. In some cases, there may be valuable but non-liquid property that cannot be sold quickly to pay taxes. In other estates, it may be the direction of the will or the desire of all concerned that family assets should not be sold to pay tax but rather retained by the next generation.

Life insurance is one fairly obvious way to arrange liquidity to pay taxes arising on death. But the availability of enough life insurance coverage on reasonable terms to meet the likely tax obligations depends on a number of factors, including age and health.

One kind of life insurance contract, however, is uniquely well suited to these needs. It's called second-to-die insurance.

This kind of policy is issued on two lives jointly, with the insurance premium based on the spouse with the better life expectancy. One spouse can be uninsurable for purposes of a second life insurance policy, but the joint policy would still be available, with premium rates based on the age of the younger spouse. Generally, insurance coverage is more likely to be available and at a lower premium with this kind of policy.

There are no insurance proceeds on this kind of policy when the first spouse dies. But it can likely be arranged that there's no tax to pay at that time either.

On the second death, the insurance proceeds are paid to the estate or directly to the beneficiaries, and available to pay taxes on capital gains or remaining balance in RRSP or RRIF accounts.