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Need Another Tax Shelter? Try Insurance

It’s often forgotten that life insurance has tax shelter features in addition to its other benefits. Keep this in mind when talking tax and estate strategies with your financial advisors.

Life insurance may play multiple roles in tax and estate planning, but its ultimate suitability for you depends on your unique situation. Important variables include your age, medical history, income and tax bracket, risk tolerance, investment choices, and withdrawal strategies. Proceed with caution, crunch the numbers first, and talk with your financial planner before buying life insurance with tax or estate planning in mind.

While many life insurance products are available in the marketplace, they are generally either term insurance or permanent insurance. Term insurance is simply pure insurance against the risk of your death in the current year, and usually has lower premiums at younger ages. It’s the type of policy many business owners have to make sure their families or businesses are provided for should they die unexpectedly. Permanent insurance, commonly called whole life or universal life, combines life insurance coverage with an additional investment savings component and, as a result, often has higher premiums than term insurance.

Universal life (UL) policies are structured as “exempt life insurance contracts” that allow you to pay insurance premiums and make deposits to a tax-sheltered investment account (“side fund”) simultaneously. You can choose from a variety of investments (equities or bonds, for example), depending on your risk tolerance. The insurance premiums are not tax-deductible, but income earned is tax-sheltered until the policy matures. If you withdraw funds during your lifetime, they are taxable to the extent the amount withdrawn exceeds the adjusted cost base. Or, if you withdraw funds as a loan against the policy, they are then repaid from the death benefit. When you die, the entire amount – original insurance amount plus accumulated cash value – is received as a tax-free death benefit.

UL products can play a role in:

  • Funding of capital gains or RRSP tax liability.
  • Estate equalization. You may wish to leave your business to beneficiaries active in that business, and an equal non-business asset such as insurance funds to others.
  • Business succession planning.
  • Tax-sheltered long-term investment strategies to supplement retirement income.

When buying insurance for the above reasons, give some thought to your policy’s beneficiary. If your estate is the beneficiary, the proceeds will become part of your estate on your death and be subject to any creditors’ claims on the estate. The proceeds also will be subject to probate fees. You may want to name your spouse or another beneficiary so as to bypass the estate and protect the investment fund or cash surrender value from creditors during your lifetime.

Some insurers recommend UL policies as tax shelters, particularly for clients who have used up their RRSP contribution room but still have excess cash to invest. The CRA limits the amount you can contribute to a policy’s side fund but, depending on your age, it could be as much as 3 times the cost of the life insurance. The savings portion could be greater than your RRSP contribution limit, more than doubling your tax-free compounding.

Once your UL account has built up over several years, you can maintain your insurance coverage by having your insurer withdraw funds from the investment account to pay ongoing premiums. This means the premiums are now being paid in pre-tax dollars.

Another advantage of UL insurance is that investments can be switched within the plan without attracting capital gains tax. And foreign content is not restricted.

Some very complex insurance products available today combine UL insurance, disability insurance (replaces your income if you are medically unable to work) and critical illness insurance (pays a lump sum if you develop a critical illness such as cancer or heart disease). Normally, disability and critical illness insurance policies are paid for in after-tax dollars. Bundling them into a UL contract means they can be partly funded with pre-tax dollars.

Insurance companies also promote funding flexibility as an advantage of such combination policies for business owners or commissioned salespeople with fluctuating incomes. Stand-alone disability policies require level annual premiums for the term of coverage. If your income drops temporarily and you miss payments, the insurer might cancel your coverage. A combination policy lets you contribute when times are good, within CRA limits, and scale back if income falls.

While UL insurance may sound like a good tool, some critics suggest it’s overrated as a retirement investment strategy because of hidden costs and lack of policy guarantees. Be aware, first of all, that UL is very complex and often subject to extra commission costs and taxes that ultimately lower your return. As well, life insurance companies reserve the right to unilaterally make adjustments to various details of UL plans, including policy lapse assumptions, rates of return, and taxes on premium deposits. Under certain conditions, they also have the right to change the amount of life insurance coverage or premiums paid, and even to lapse the policy.

If you think you might need to draw on your life insurance to supplement retirement income, other investments could well be more suitable. Generally speaking, because of charges built into permanent insurance, 10 years seems to be the break point when returns on an insurance investment start to surpass returns you could earn on other non-registered investments. If you aren’t prepared to put your money away for at least that long, reconsider buying permanent insurance like UL contracts.

Using life insurance as an investment strategy is complicated and not suitable for everyone. Be sure to consult your financial planner before you buy.