Doing the Perm / Term Squirm Part 2: An Introduction To Permanent Life Insurance
If you’ve read my first article in this series, you probably know more than you really want to know about term life insurance. It’s now time to talk about the other side of the equation: permanent coverage.
To recap, while term insurance is a simple tool with a few add-on features, permanent life insurance is like a Swiss Army knife that can do pretty much everything except make your bed and laugh at your jokes. Of course, whether this is worth the extra costs that can go along with these features and whether it is the best tool for your situation is an entirely different question. Sometimes, permanent life insurance can be a game changer. Sometimes, it can do a pretty good job but there might be other products or solutions that do an even better one. Sometimes, the wrong permanent policy can even leave you worse off than when you started. This article (and my ensuing) articles are designed to help you make informed insurance choices.
Types Of Permanent Life Insurance
At the risk of oversimplifying, I will attempt to reduce the various types of permanent life insurance into four basic categories, although I’ll refer to all of them collectively as “permanent life insurance”:
1. Term to 100 (“T-100”);
2. Non-Participating Whole Life Insurance (“Whole Life”);
3. Participating Whole Life Insurance (“Par Policies”); and,
4. Universal Life (“U-Life”).
Within each of these categories, there are lots of different options and features. Many of these differences centre on what that policy is trying to accomplish. For example, if the policy is designed as a tax-sheltered investment, it might have features that focus on allowing you to shelter as much money as possible or keeping the amount you actually pay for insurance premiums as low as possible so that more of your money can go towards investing. On the other hand, if you are more of a worrier, the policy might allow you to pay for a lifetime’s worth of coverage over a set number of years so you don’t have to fret about the policy lapsing during retirement if you run out of money to pay into it. Likewise, such policies might guarantee that they are worth a certain cash value as time progresses so that you have a secure source of extra funds in the event of a rainy day.
When discussing tax issues and rules regarding these policies in future articles, I’ll focus primarily on the rules that apply if you bought a new policy today. Different rules apply to some older policies (such as those from before December 1, 1982) and new rules will be introduced in a few years for policies purchased in 2016 onward (at least, that’s the current prognosis). In most cases, the old rules are the most favourable to policyholders and the new rules coming down the pipe will be the most restrictive. Essentially, the anticipated changes will restrict the amount of money owners can salt away in their policies above the basic premium costs. They are also designed to standardize how the rules are applied from insurance company to insurance company while also updating the “mortality tables” (the statistical assumptions regarding how long people live) to take into account increasing lifespans.
There are two main takeaway points from the various changes to the tax law that apply to insurance policies:
a) if you have a policy from December 1, 1982 or earlier, get professional advice before you make any changes to it so you don’t lose special tax advantages; and,
b) if you’re interested in life insurance for investment purposes or estate maximizing, now is the time to act, as policies issued before the new laws come into force will still benefit from the current rules.
Potential Uses Of Permanent Life Insurance – Getting Started
As there is no way I can adequately describe the different types of permanent life insurance without this article reaching novel length, I will reluctantly restrain my remaining commentary to using life insurance to maximize what you leave behind for the next generation. On the other hand, this is only a reprieve; future articles detailing the different types of coverage and options are already in the works!
When learning about the various uses of life insurance, I suggest keeping the following points in mind:
• Your policy might be used to accomplish multiple purposes at the same time. For example, besides providing money to protect your family or pay your final tax bill, the same policy might also be a way of supplementing retirement income;
• The purpose for owning the policy can change over time. For example, even though you may no longer need the policy to replace lost income on your death, you might decide to keep the policy for estate maximization or to pay your final taxes;
• Life insurance works best if you actually need that payout at death. Although using insurance for retirement funding or creditor protection can be a wonderful thing, it might not be the best solution if you don’t also have a more traditional reason for owning the policy.
Estate Maximizing
Life insurance isn’t only a way to provide money for your family if you die ahead of schedule – it can also be a way to leave more to your family even if you live to a ripe old age. For clients in high tax brackets and with ample savings, Par and U-Life Policies both offer the opportunity to contribute extra money (subject to set limits) beyond what is required to pay for the death benefit initially promised under the policy. This extra money is more of an investment than insurance, as the returns depend on the insurance company’s own profits (Par Policies) or the investment results from money that is invested in mutual fund or GIC-like products chosen by the policy owner from a range of options provided by the insurance company (U-Life Policies.)
These extra contributions are seen as pre-payment of future premiums but, if the investment gods smile in the policy owner's general direction, the investment returns can actually increase the eventual payout at death. Why are some people so excited about this option? There are several reasons:
a) Tax-free growth inside the policy.
Other than a miniscule premium tax, the extra money generated by the investments inside the policy grows tax-free. As a result, each year the client has more money left to reinvest, which means that returns can potentially compound a lot quicker than if the government was taking its pound of flesh each year or every time you sold a stock or mutual fund.
b) Tax-free payout at death.
Not only does your money grow essentially tax-free when inside the policy, it gets paid out tax-free at death as well. This gives insurance a huge advantage over other investments, even those that are subject to deferred capital gains such as real estate and equities, which usually can only delay but not avoid their day of reckoning. As an added bonus, if owned inside a Canadian-controlled private corporation, not only does the company receive a huge tax-free cheque when the insured dies, this death benefit qualifies for special tax relief. The company can avoid all or most of the extra personal level of taxes that apply when a company pays out dividends; the life insurance proceeds can be paid out from the company as a tax-free “capital dividend.” A corporately-owned policy thus avoids the scary-high investment tax rates during life, gets a tax-free payout at death and, if that isn’t enough, minimizes the tax hit to the people actually getting the insurance loot.
c) Creditor Protection.
If the policy is owned personally and the named beneficiaries are qualifying family members of the person insured, then the policy may be creditor-protected during the owner’s life. It is also exempt from creditors of a deceased policyholder’s estate if it is left outside the estate and the beneficiaries aren’t jointly liable for the debts. This protection isn’t iron-clad, as family law claims may still apply, and payments into the policy in the year before bankruptcy are also up for grabs, as might payments one to five years before then if your creditors can show that you knew bankruptcy was coming at that point. Ultimately, the people who might benefit the most from this type of protection are those who don’t have any immediate creditors but who might be involved in a risky profession or those who merely like the added security in case their situation ever changes.
d) Potential Will Challenge Protection.
Although claims by surviving dependants might be another matter, leaving your life insurance outside of your estate should be enough to avoid claims made by adult children under British Columbia’s Wills Variation Act. Since beneficiary designations are not public documents, unlike wills, your greedy adult children may never even know about a policy left to charity or to that child who took care of you in your old age.
e) The Ability To Fix Your Costs.
Unlike term coverage, many permanent insurance policies (particularly Whole Life and Par Policies) allow you pay for a lifetime’s worth of coverage over a set period, of say 10, 15 or 20 years. Because the insurance company gets more of your money sooner, they are able to offer you a deal on the premium costs over this set period. You even get a slightly better deal if you pay your premiums annually rather than monthly. While some clients plan on continuing to pay into the policies after their required funding period lapses to take advantage of the tax-sheltering features, many also appreciate the peace of mind that comes with knowing that they won't have to continue paying into the policy during retirement and also have the cash value of the policy to fall back upon in emergencies. Others may simply like being able to crunch all the numbers in advance in order to make the rest of their estate or life planning that much easier by guaranteeing a minimum estate value.
f) Coverage for Life.
Unless you convert your term coverage to permanent coverage while you have the chance or die before your term policy expires, you run the risk of outliving your insurance coverage. Accordingly, while term coverage is a great way of getting maximum coverage for the minimum price in the short term, it really isn't suited for needs that last a lifetime, no matter how long.
Conclusion
Although we have started the discussion about permanent life insurance, I have really only scratched the surface. Next time, I will discuss using permanent life insurance for retirement planning. In the meantime, I hope that your 2014 sees you healthy, wealthy and wise.
Colin S. Ritchie, LL.B., CFP, CLU 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