With their death benefits, insurance plans not only offer protection by covering lost income, they can also be part of a smart tax strategy.hyejin kang/iStockPhoto / Getty Images
Most Canadians understand how term life insurance protects their families. However, financial advisors can find themselves with much explaining to do around using permanent life insurance as a financial and estate planning tool.
“In our practice, this discussion comes up all the time,” says Elizabeth Harding, director, wealth management, and investment advisor with the Orlic Harding Cooke Wealth Management team Richardson GMP Ltd. in Burlington, Ont. “I like to talk about the difference between the two as ‘if I die insurance’ versus ‘when we die insurance.’”
Both have a place, with their tax-free death benefits. Term life insurance covers the “if I die” scenario. Ms. Harding says it’s useful during someone’s income-earning years. For as little as a few hundred dollars annually in premiums, its benefit will cover lost wages to support the client’s young, growing families.
Permanent insurance addresses “when we die” concerns around taxes. That’s often a more suitable topic of discussion for freshly retired clients or those approaching retirement.
“These are folks who have worked hard to pay off debt, educate their children and create a net worth that gets them through retirement,” she says.
These investors are likely to leave behind a substantial estate with a big tax bill to go along with it. Enter permanent life insurance. These plans can be an important source of liquidity for the estate, but can be a tough sell to clients due to the cost of the premiums, Ms. Harding says.
Term is cheaper in the short term, but becomes prohibitively expensive over time. In contrast, permanent insurance has much higher premiums, but they won’t ever increase.
Why go this route? Ms. Harding says the insurance company invests a portion of the premium to offset future costs of funding the policy. This money grows, tax-deferred. After a set period, the sum usually has a cash value to the client over and above the death benefit. This sum is often referred to as the cash surrender value (CSV), and Ms. Harding says it can provide clients with a lot of flexibility.
For example, depending on the policy’s structure, the CSV could be used to purchase an annuity. Alternatively, clients may be able to stop paying premiums, with the CSV funding future premium costs. As well, a permanent life policy may be used to increase the tax-free death benefit in some instances. Policyholders may also be able to withdraw the CSV as taxable income or borrow against it to generate tax-free cash flows, Ms. Harding says.
Still, permanent life insurance is a big financial commitment compared to term insurance. Cynthia Kett, principal at Stewart & Kett Financial Advisors Inc. in Toronto, says advisors must discuss with clients the need to be able to commit to paying premiums for at least 10 years if they choose the permanent life insurance option.
“[Otherwise,] the associated policy fees and cancellation charges are very high until that time period has elapsed,” she says.
Permanent life policies are the best fit for clients who have sufficient funds to max out their registered retirement savings plans (RRSP) and tax-free savings accounts and who have money left over to fund the ongoing premium, Ms. Kett says.
One way advisors can ease the premium burden is to encourage clients to purchase a policy sooner rather than later, says Doug Nelson, president and senior financial planner at Nelson Financial Planning Corp. in Winnipeg.
In this case, he says, advisors must then pay attention to the negative effects of long-term inflation on the death benefit.
Consider a policy with a $500,000 benefit purchased by clients in their 50s. The policy could lose more than half its purchasing power over 40 years, based on a 2 per cent inflation rate. In this case, the future value of $500,000, after inflation, would be $225,000.
“The big question becomes: What is the future tax liability expected to be, and how does it compare to the $225,000 amount?” Mr. Nelson says.
Thus, advisors need to forecast the value of taxable assets as far as 30 to 40 years into the future, which may pass through a client’s estate.
Among those potential taxable pieces of the estate is the RRSP and/or registered retirement income fund (RRIF). But Mr. Nelson argues that the registered account’s tax liability is likely a less important consideration for a permanent policy.
Why? If the last survivor reaches his/her 80s, mandatory RRIF withdrawals are sizable enough to grind down the value of the account quickly, likely leaving an inconsequential tax bill for the estate.
Often, the bigger concerns surround properties such as a family cabin. These assets can have large taxable capital gains that may exceed what beneficiaries (e.g. the children of the deceased) can afford. This can lead to the sale of beloved family treasures.
Ms. Harding says a permanent insurance strategy should then be designed to address tax liabilities for any illiquid asset that a client may want to keep within the family. These are also items of high value: an antique car, rare coins, luxury watches and jewellery, and fine art. As well, a policy could be used to pay taxes associated with investments held in open accounts.
For this need, clients typically have two broad permanent life insurance policy options to select from: whole and universal. A universal plan offers more flexibility on premium payments and choice of investments.
“It behaves more like an investment account with the potential for growth of cash value in the policy above and beyond the death benefit,” Ms. Harding says. “By contrast, a whole [life] plan is less flexible regarding premiums, but it provides more stable growth of the cash value in the policy.”
Although whole life policies are a little more straightforward, advisors may recommend a universal policy. That’s because it comes with lower premiums than whole life, with a similarly sized death benefit.
Universal life policies don’t offer the same potential cash value growth above and beyond the benefit as whole life policies. However, universal life policyholders have the option to increase premiums in the future to boost the policy’s long-term cash value.
Whether choosing universal or whole policies, permanent life insurance has the potential to be an excellent source of liquidity for estates. Clients can use these policies to create enough value in the death benefit to cover some or all of the taxes owing.
“They may not be able to avoid the tax bill,” Mr. Nelson says. “But it should take fewer dollars to fund the insurance than to pay the tax bill."