When we are younger, we worry whether we have enough life insurance coverage to provide for our dependants in the event of a premature death. As we get older that threat seems to subside somewhat as children cease to become minors, debt gets paid off and our net worth increases. But does that necessarily mean that we should allow our insurance policies to lapse?

Not necessarily. What happens when we get older is that the role of insurance changes from providing financial support on premature death to insurance being used as a financial hedge against taxes on our death. After all, all our RSP’s, 401(k)’s and analogous structures are government sponsored tax deferral strategies. At some point, you can’t defer these taxes anymore and you would rather have the insurance company pay than your estate. Let me explain.

At death, there is a deemed disposition (a disposition is a fancy word for a sale) of all your assets at market value (there are provisions which allow some assets, such as a principal residence, to be subject to a roll-over to your spouse on a tax deferred basis). If you purchased the assets a long time ago, and assume natural price appreciation based on inflation alone, the estate’s tax bill is generally equal to the profit on the deemed disposition. This can be quite a  significant tax hit.

Since taxes and debt are paid out of the estate before any distributions to beneficiaries can take place, one has a large issue of how to maximize the distribution. This is where insurance plays a large role.

The estate is actually not using the insurance to pay the beneficiaries but using it to pay taxes the estate is owing to the government so that it can distribute as much of the estate as possible having used the insurance company to settle the tax bill. The analysis starts at different points but gets you to the same place.

Thus, as you get older, your analysis is moving from: (a) how much money do my dependents need if I were to prematurely die to (b) what is my tax bill if I die. You most likely get to (b) if your dependents are no longer dependents.

The calculation, therefore, goes from income replacement to: (proceeds of disposition of estate at fair market value) – (acquisition value) = taxable gain. Now take your tax gain and multiple by applicable tax rate = amount of desired insurance. Your accountant can help you come up with the numbers.

The amount of desired insurance can be more or less than your current coverage but adjustments to the insurance policy should be made on that above formula and not on what your insurance broker thinks you need. If you are a saver and buy and hold people, you may have to adjust your policy upwards since your gain may be significant and your tax hit high.

You may actually end up in a strange situation where your life insurance coverage was adequate as income replacement for your dependents but not as a tax hedge upon death if you invested wisely over the years (talk about the law of unintended consequences!).

If you want to read a good insurance based blog, please visit Riscario Insider who is an actuary in the insurance industry and a frequent commentator.

…please don’t forget to thank a war veteran today for their sacrifice and please wear a poppy.