Life Insurance
Overview
Life insurance is a tool that ensures your loved ones are financially supported upon your death. Through a contract between the insurance company and yourself, the policyholder, you exchange premiums for the promise of a beneficiary for your loved ones. This is also known as a death benefit.
You could be the owner of your life insurance policy, or you could designate ownership to a spouse, some other related person, or your company.
Life insurance can be used to pre-fund future expenses when you pass away. It’s a tax-efficient option that allows your loved ones or company to use the funds for a number of things. The death benefit could go towards supporting your dependents, funding the transfer of your wealth to the next generation, paying for capital gains taxes, financing shareholder buyouts, or making charitable donations.
A huge benefit of life insurance is the tax-free nature of the death benefit. Whomever you designate this benefit to can accept the funds without paying taxes on them. Additionally, the premiums you pay for the policy after the cost of the insurance is fulfilled will continue to grow tax-free. When you designate the funds to go to a company, the company receives them in the form of a capital dividend account credit.
Life Insurance Uses
Life insurance gives you a tax-free option for funding a number of different financial needs when you pass away. This liquidation can fund income replacement, capital gains liability, intergenerational wealth transfer, buy/sell agreements for shareholders, retirement income, and charitable donations.
Replacement of Income
One of the biggest benefits and uses of life insurance is to protect your family from the loss of income that occurs when you pass away. Your beneficiaries receive the death benefit from your policy which they can either invest or purchase an annuity with. An annuity converts the benefit into a source of income that gets disbursed over time to replace some or all of your recurring income.
With that in mind, it’s important to understand how much life insurance is enough to protect your family. The answer varies from family to family. It all depends on the incomes of both parents, the debt you hold as a family, if your spouse works, if you have assets that could be sold to create income, as well as how much you want your policy’s death benefit to be worth. You might want the death benefit to cover a temporary amount of time, or for it to be a permanent source of income for your beneficiaries.
Capital Gains Tax Liability Funding
Capital gains are a type of estate tax liability that arises when the person who passes away owns shares or real estate (excluding their principal residence) that have a value which exceeds their original cost base. It’s common for policyholders to pass their shares or real estate onto their children. However, this transfer signifies a deemed disposition to the government of a “sale” of the property in which tax is due. This tax puts a burden on your family members or fellow owners of the capital property, especially if they aren’t prepared to pay it.
The best solution for pre-funding this expense is life insurance. Since you know that this liability is present and impending, you can prepare for it. Life insurance is the most tax-effective method.
Estate Tax Liability Funding
Life insurance policies that are owned by a Canadian Controlled Private Company will receive some or all of the death benefit as a capital dividend account credit. The company can use the credit to reduce the capital gains liability tax, and be considered as part of any estate freeze.
Intergenerational Wealth Transfer
Life insurance can be used to invest in future generations. The tax-free death benefit provides funding for various financial needs your beneficiaries may have. Affluent Canadians often have a portfolio of investments that can be used in future generations’ lifetimes. They include stocks, bonds, real estate, savings, or the sale of a business. You might use mutual funds, hedge funds, pooled funds, or work with a broker directly. In addition to these investment options, life insurance is an effective option for enhanced intergenerational wealth transfer.
One option for life insurance is a Whole life insurance policy. This policy is tax-exempt, provides an exceptional rate of return, and works well as part of a diversified portfolio since it is an alternative to a taxable fixed income investment.
Retirement Income Funding
Certain policies have cash value, and the equity inside represents an asset. As your policy ages, the cash value increases and gets reinvested back into the policy on a tax-sheltered basis. It can be used as collateral for a loan or simply paid out to the policyholder should the policy be cancelled. Someone in their 30s, 40s, or 50s could have purchased a policy for income replacement or debt cancellation needs, but then use it in their 60s or 70s for supplemental income during retirement. Essentially, the policyholder borrows against the cash value of the policy and pays off the loan using the death benefit. This tedious yet highly effective strategy enhances your income during retirement.
As an example, let’s say you’re currently a 35-year old woman in Canada. You’ve purchased a permanent life insurance policy that includes premiums payable over 20 years. Assuming you leave the cash value where it is, by 60 years of age it will have grown quite substantially. At this point, you could use the cash value to take out a loan and the interest be capitalized. The income you receive from the loan can be used for anything you wish, including living expenses as a retiree. During this time, the death benefit in the policy continues to grow tax-free. When you pass away, the loan can be paid off with the death benefit and any excess funds can go to your beneficiaries.
Charitable Donations
Life insurance can be used to fund your charitable giving. One way of doing so is applying for a life insurance policy and transferring it to the charitable organization you wish to support. To fund the policy each year, you would donate the amount required for the premiums and receive a charitable receipt in return. Another option is simply donating an existing policy to an organization. You would then receive a donation credit equal to the fair market value of the policy to reduce taxes owing.
One strategy some affluent Canadians use life insurance for is to name the charity as beneficiary of their life insurance policy or state in their will that the death benefit proceeds are to go to a named charitable organization. When they pass away, the benefit is used as a donation and the donation tax credit gets used to pay estate tax liabilities.
Life Insurance Types
The two types of life insurance are Term Insurance and Permanent Insurance. In both types, the policy can be issued as a single life policy or a joint life policy.
In a single life policy, one person is insured and the death benefit gets paid out upon that person’s death. On the other hand, a joint policy insures two people, usually spouses. The death benefit payout varies between first-to-die and second-to-die options. Often, couples will opt for second-to-die policies which means the capital gains liability tax isn’t payable until the second spouse passes away.
The joint second-to-die policy is popular because it carries lower premiums than single life policies for the same face amount. This is because the life expectancy of two people combined is longer than a single person’s life expectancy. The downside is that joint second-to-die policies can’t be easily separated should the marriage end.
Term Insurance
Term life insurance provides coverage for a fixed duration of time with a fixed premium. They often last for 10-20 years and will renew at the end of each term automatically, no medical evaluation needed. When you renew the policy, however, it will adopt the current premiums which are higher than what you paid in the previous term. There’s no cash value in the policy and it expires at 80 years of age. It’s often chosen for its low-cost advantage to provide temporary coverage.
It’s possible to convert term life insurance policies to a permanent insurance policy from the same company. This usually must be done before the policyholder turns 70 years of age. The new premiums will be based on the age of the insured when they make the transition.
It’s common for term insurance to be used in the family market where vast coverage with low premiums are in demand. It’s a budget-friendly solution for families with young children. Term insurance is also used in business when temporary insurance is needed to meet the conditions of a loan, key person coverage or funding for shareholder agreements.
Permanent Insurance
Unlike term insurance, permanent insurance policies protect the policyholder for the duration of their life. There’s no expiry date and the premiums stay the same. It comes with a death benefit payable when the insured passes away.
It’s important to determine what your insurance needs are prior to making a decision to purchase one over the other. A strong insurance advisor should be able to guide you to the correct decision. It all depends on the duration you need the insurance for, your need for a death benefit, your interest in tax-free investment options, and your ability to pay premiums.
Permanent life insurance policies are unique in that they can be designed with premiums only payable for a limited time frame. They can also grow in tax-free interest or dividends. Within the permanent life insurance option, there are two primary types: Whole life insurance and Universal life insurance.
Whole Life Insurance
Whole life insurance covers the policyholder for their entire lifetime. It comes with a death benefit which can increase with paid-up additions. The Canadian market has a long relationship with whole life policies in which it’s considered stable and trustworthy.
Whole Life Insurance Investment Account
Whole life policies contain an investment fund called a Par Fund. It’s structured quite conservatively, similar to a balanced fund. The fund invests into assets such as bonds, mortgages, real estate, alternative fixed income, and a small percentage in stocks. There’s very little volatility because the returns are smoothed, or amortized. You can expect a consistent rate of return which is appealing to risk-averse investors.
Participating and Non-Participating Whole Life Policies
There are two ways whole life policies are issued, participating and non-participating. Although they have similar structures, there are some major differences.
In participating policies, an annual dividend is paid. This is also known as a “current dividend scale”. These policies are offered by a number of different insurance companies in Canada such as SunLife, Canada Life, Manulife, and Equitable Life, to name a few. The dividend scale includes the mortality of all the other policies within the Whole Life block of business. It’s more common for people to live longer today, so companies haven’t had to pay claims that they originally anticipated. So, there’s a mortality gain element in the dividend scale.
Non-participating policies are offered by a few companies such as BMO Insurance and Manulife. These policies guarantee the cost of the insurance and each policy earns performance credits instead of policy dividends. Where a participating policy includes all changes to mortality in the block of business, a non-par policy is only based on the investment fund.
When interest rates decrease, the dividend scale and performance credit declines. However, in both participating and non-participating policies, the gains and losses are amortized over time, smoothing. So, the policy rate lags behind the current market rates. With a whole life policy, you’re guaranteed a positive rate of return.
Dividends
For over 125 years, major insurance companies have declared whole life dividends, even through both world wars and the 2008 financial crisis.
When the policyholder receives dividends paid, they have a few options. Often, they will use the dividends to buy “paid-up additions” (PUAs). PUAs are a form of insurance in addition to your regular coverage. They increase the growth of the policy and earn more dividends as more PUAs are purchased.
With a rising dividend scale, policies may be able to be placed in premium offset sooner than expected. This is due to the higher cash values and higher death benefits. On the other hand, a declining dividend scale causes lower cash values and death benefits. It can even delay the usability of premium offset.
The dividend scale lags behind the investment climate because of the smoothing of performance in the investment fund. When interest rates for bonds decline, the dividend scale also declines but far slower than the interest rates. Likewise when interest rates increase. Smoothing reduces volatility and sharp changes from short-term moves.
Whole Life Premiums
There are three options for premiums in a whole life insurance policy. The first is Basic Premium Only. The second is Basic Plus Term Option. This is the combination of basic and term option to allow the policyholder to buy more coverage. It’s essentially whole life and term that reduces over time. In this option, premiums must be paid for longer. The third option is Basic Plus Deposit Option. In this option, there’s an additional premium that allows the policy to be paid in full sooner. This results in higher policy values, despite the maximum deposit which ensures the policy stays tax-exempt.
The cash value of a whole life policy combines guaranteed cash and excess cash which varies depending on the dividend scale. Policies can be designed to include a number of premiums paid over a set number of years. Once these years have passed, the policy can enter premium offset which means the policyowner doesn’t need to pay any more premiums. All future premiums get paid by the policy and PUAs get surrendered with all dividends to pay those future premiums.
Policy Structures
There are three typical whole life policy cost structures. They could have a life-pay which means they’re paid for the duration of the holder’s lifespan. The other cost structures are the 10-pay and 20-pay which means the holder doesn’t have to pay anything for the insurance until 10 or 20 years have passed. The 10-pay and 20-pay have higher premiums and lower cash values in the beginning.
Whole life policies can also be designed with either high early cash and death benefit values, or high long term cash and death benefit values. The crossover point when the high long term values exceed the early values is approximately in year 20. When your policy has a high early value, it provides better balance sheet management. By the policy’s 7th year or so, the cash value is the same as or exceeds the premiums paid. The high long term value policy is most suited to those who want to capitalize long-term values and don’t desire early cash values.
Universal Life Insurance
Designed in the 1990s, the universal life insurance plan offers immense flexibility and control for the policyholder. Every aspect of the policy, including investment options and policy fees, are identifiable. One strategy for using a universal policy is to only pay the cost of the insurance so the policy acts as a term-to-100 policy. This means there’s no cash value or increasing death benefit. Another strategy is for the policyholder to deposit premiums that exceed the cost of the insurance. The extra premiums can get invested in one of the policy’s investment options. In this case, the death benefit will be equal to the amount of the policy in addition to the investment, also called Face Plus.
Income earned from universal policy investments is tax-free. However, if the excess premiums are invested in non-guaranteed funds, the policy can have negative rates of return. Policyholders can avoid negative rates of return by investing deposits in guaranteed interest rate accounts. Universal policies come with many investment options that vary by risk-tolerance. The policyholder can decide which options are best suited to their investing style.
There are two types of guaranteed insurance costs: level cost of insurance (LCOI) and yearly renewable term (YRT). With YRT, the early years of the policy have low costs of insurance. As life expectancy approaches, it increases sharply. The low insurance costs produce higher early cash value. In later years, the cash values or premiums will need to cover the inflated insurance costs.
Before committing to a policy, examine the expected rate of return. With universal life insurance, you can alter your premiums over the years as long as the cost of insurance is covered.
Ownership
Corporate and Personal Ownership of Life Insurance
Both an individual and a company can be the owner of a life insurance policy. A person who is insured can be the owner of his/her policy, or the owner can be a company that he/she controls. When the person insured isn’t the owner of the policy, the insurance company requires the owner have an “insurable interest” in the person they are insuring. This prevents people from owning policies on strangers or those they have no relation to.
When an individual owns their policy, it’s called personal ownership. The owner could be a parent that owns a policy on their child, a wife owning a policy on her husband, etc.
When a company owns the policy it’s called corporate ownership. Companies can own policies for specific employees or shareholders. This form of ownership is beneficial for business owners’ estate planning.
So, is it better to own a policy personally or place it under the company’s ownership? It depends on your purpose for the insurance. For example, a personal policy might be the right decision if your aim is to use it for personal estate planning. It may be needed to aid in intergenerational wealth transfer or to pay estate taxes. You might want to use a corporate ownership policy if your goal is to protect a key person in your company or you want to secure a bank loan. Individuals who own a company can use corporate ownership to aid their personal estate planning needs. There are advantages to using corporate funds to pay premiums on personal policies. Corporate ownership is also beneficial when there is significant retained earnings, and the death of a shareholder would trigger a death benefit in the form of a capital dividend.
One situation that is best avoided is using corporate ownership and listing your spouse as the beneficiary. This could cause a taxable benefit to the shareholder. To minimize financial or litigation risk of an operating company, it is recommended to own the policy personally or place it in a holding company.
Capital Dividend Account
CDA, or capital dividend account, is a notional tax account that tracks specific amounts received by a corporation. The funds in a CDA can be paid as capital dividends to shareholders, tax-free. Examples of tax free receipts that credit the CDA are the non-taxable portion of capital gains, capital dividends received from other corporations and proceeds received from the death benefit of a life insurance policy in which the beneficiary is the corporation.
CDA credits from death benefits are equal to the amount of the death benefit, less the adjusted cost basis (ACB). Often, policies that are held until life expectancy will result in a significant amount of the death benefit credited to the CDA. That being said, policies issued after 2016 might have higher ACB due to tax changes.
Capital dividend accounts allow corporations to share life insurance proceeds among their Canadian shareholders, tax-free. Through advanced planning and strategizing, these proceeds can reduce capital gains tax liability. Corporate-owned life insurance is one of the most powerful insurance strategies used in estate planning.
