Buying And Investing Inside Universal Life And Permanent Life Insurance Policies � Tips For Potential And Current Policyholders

Colin Ritchie Do you own an incorporated business or holding company? Are you a wealthy Canadian looking for additional tax-sheltering opportunities? Are you someone who is looking for investment opportunities with some potential creditor protection and preferred tax status? What if you have more money in your holding company than you will never spend in your life and are looking for a way to both reduce both your final tax bill, as well as the cost to your heirs and estate of getting this money out of your company? If you can answer yes to any of these questions, or have already done so and presently own permanent life insurance, I suggest diverting a few moments from making your New Year’s Resolutions and reading on.

Sadly, by the time you read this humble offering, any permanent policies you purchase in the future will not be as attractive as those issued before the end of 2016 – as I have written about previously, a host of changes to the tax rules will water down some of the potential tax savings and effectively eliminate some of the more exotic tax-planning strategies. On the other hand, permanent life insurance can still offer an embarrassing amount of tax-minimization and estate-maximization benefits when the right product is matched with the right client. The next few pages will outline for those of you who already own permanent insurance, as well as those of you who don’t but might benefit from taking out a policy, some of the reasons why permanent life insurance can be an effective tool in the war against taxes. The companion article to this piece outlines some of the ways of reducing risk when investing inside permanent insurance policies, in addition to ways of heading future problems off at the past before mere disappointment turns to financial despair. As is the case when owning an investment portfolio, an insurance policy must be managed carefully and potentially rebalanced in order to produce the best results. Unlike an investment portfolio, however, there are a host of other things you need to stay on top of when owning permanent life insurance other than just asset allocation in order to minimize the chances of things going awry and to optimize its value. Stay tuned next month to find out more!

Many thanks to my friend and life insurance pro, Lee Brooks, BBA, CFP at View360 Insurance Advisory, for helping to prepare this article, particularly regarding insurance investment options as detailed in the second installment.

Life Insurance - The Tax Benefits

The most obvious, the most common and probably the best use of life insurance is to protect your family from economic catastrophe if you die ahead of schedule. In instances like this, such as when you have a young family and the size of your bar tab exceeds your home equity, term insurance is generally the way to go. In situations like this, your need is not permanent – as your children grow and your mortgage shrinks, the economic impact of your unexpected demise will hopefully decrease, as should the size of your insurance policy designed to cover off this risk. Moreover, as money may be tight and there are many other things clamoring for your financial attention, such as debt repayment and retirement funding, buying cost-effective term coverage allows you to get the amount of coverage you need while still hopefully having enough money left to address these other concerns and perhaps even vacation on a tri-annual basis.

Moreover, for most of us, there will come a happy day when you and your family have enough dollars in the bank so that no one will need sell the family heirlooms to make ends meet if you suddenly passed into the great beyond. Or, alternatively, perhaps the day comes when you decide that your children are now old enough to be responsible for their own financial future and you now wish to spend the money you’ve previously committed to life insurance on violin lessons or on your wine collection. In either instance, that might be the time to cancel your insurance as it is no longer needed. Thus, why buy permanent insurance at considerably higher prices when insuring only a temporary need?

On the other hand, some people realize one or more of the following:

• They will never be able to spend everything they own, particularly inside of their holding companies, and want to look at tax effective ways to maximize their estates;

• They wish to leave behind a minimum legacy for their family or at least enough money to pay their final taxes without having to sell the family cabin, the family business or other legacy assets;

• They want to ensure there is enough money to provide a fair inheritance to all of their heirs and need extra assets to ensure that they can pass along the family business, farm or house to some children while still providing enough for their other offspring; or

• They hate paying tax and want to know about other ways of funding some of their retirement rather than tax coffers;

Permanent life insurance can meet these needs in the right circumstances. As most of us know, it provides a tax-free payout at death to provide instant liquidity to pay final tax bills or guarantee a minimum estate. Some of the subtler benefits are as follows:

• Universal Life Insurance Policies (“UL”) offer an investment component that can increase the payout at death. This investment account is funded by extra contributions that accumulate inside the policy. You can allocate how the money is invested among many different choices, similar to how you can decide which investments to own inside an RRSP or TFSA. Any gains remain essentially tax-free if they stay inside the policy and are added to the tax-free payout at death. As a result, the payout at death can be substantially higher than if you invested instead in similar non-registered investments that were subject to yearly taxation or capital gains upon sale, provided that the insurance costs are less than what you would have paid in taxes.

• Participating Whole Life Insurance Policies (“PAR”) pay policyholders dividends in many cases once the policies have been in force long enough based on a variety of factors. They also allow extra contributions that can earn extra dividends. If the dividends are kept inside the policy, they also remain essentially tax-free and add to the tax-free payout at death. Unlike UL policies, however, policyholders do not control how the money is invested. It is instead invested by the insurance company. Thus, like UL Policies, Par Insurance can also provide a bigger after-tax payout compared to a similar non-registered investment account at death by allowing extra investment dollars to compound tax-free, provided that the insurance costs don’t outweigh the tax-savings.

• If a policy is owned by a company, only its’ cash value is considered when determining the capital gain owing on company shares at the shareholder’s death. In other words, if a policy promises a payout out $1.4 million but has a cash value of only $400,000, then only the $400,000 value would be added to the value of any other assets owned by the company when determining the value of the shareholder’s company shares at his death for determining his capital gains bill, even though the company will still get a cheque for $1.4 million in short order.

• Continuing from the previous example, not only does the company get the $1.4 million dollar cheque tax-free; our tax system will also let the company pay out a significant portion of the $1.4 million from the company tax-free as a “capital dividend”. In other words, it helps minimize any additional taxes that would be paid by the estate or heirs that normally occur when paying dividends from companies.

• These capital dividend payments from a company can also be used to further reduce the shareholder’s final tax bill or the future tax bill of a surviving spouse who inherits the shares if the capital dividends are used to redeem and cancel out shares formerly owned by the deceased. These payments cancel out at least some of the capital gains bill that would otherwise be owing (to simplify things). Thus, not only does owning insurance in the company save money by reducing the value of the company at death for capital gains purposes; it can even cancel out some of the remaining gain with the help of a savvy tax professional.

• Insurance policies can be used as collateral for loans. Some clients use corporately-owned insurance policies as collateral for personal loans (although it is probably wise to pay the company a guarantor fee to do so). Thus, rather than having remove money from a company to pay for your retirement at potentially ruinous tax rates, you might be able to merely pay interest on a bank loan at 3 or 4% secured by your policy. Although the loan balance will probably continue to grow, so will hopefully the cash value of your policy, particularly since money inside the policy is able to compound far more quickly than if was instead invested in assets that could be taxed at more than 50% or higher inside a company in some provinces. Many banks may not even require interest payments during your life, knowing that they will be paid in full at your death when the company gets the death benefit tax-free. Even better, even though the bank will scoop some of the death benefit at that time, your company will still get credit for the portion paid to the bank when calculating how much money it can pay out to your heirs as a tax-free death benefit. Of course, if you never need to borrow against the policy to fund your retirement, your heirs will still benefit from the other tax advantages linked to insurance policies already mentioned.

Conclusion

When I talk to clients about life insurance, I seldom tell clients that they “need” permanent life insurance. In my view, life insurance is only “needed” to protect the financially dependent until they are able to fend for themselves. Generally, by the time my clients are well into retirement, this need has either vanished or the money required to keep buying life insurance would be better spent on other things, like their own retirement or, if they really love insurance, on health-related products like Long Term Care coverage.

On the other hand, even though permanent life insurance may not be “needed” in the same way as a term policy decided to ensure your child has enough money for university if you are not around to cut the cheques personally, they can be wonderfully effective tools for reducing a variety of other risks, retirement funding, protecting legacy assets like cabins and businesses, while also maximizing the after-tax size of your estate.

Despite these tantalizing words, however, it is important to think of permanent insurance policies as power tools rather than holy water. If used correctly and regularly maintained, they can do wonderful things, but they are not the solution for all of life’s ills. Moreover, just like a chain saw or electric drill, if you use the wrong tool for the job or fail to regularly maintain and service it, owning a permanent life insurance policy can certainly go very, very wrong. Stay tuned for next time, when I talk about what you can do to manage your existing and future permanent insurance policies to take some risk off the table, head potential future problems off at the pass, and to learn about new investment offerings inside insurance policies intended to help you do just that.

Colin S. Ritchie, BA.H. LL.B., CFP, CLU, TEP and FMA is a Vancouver-based fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice. To find out more, visit his website at www.colinsritchie.com.