Why combine your investments in a tax-advantaged life insurance policy? Let's look at the tax benefits, the investment options, and for whom they are best suited.
Tax advisors have been pointing their well-heeled, sophisticated clients to these unique policies for years. Depending on the insurer, the choice varies among the following basic components.
The added power of a tax deferral
You can earn and accumulate tax deferred interest. Interest not taxed on the term deposits held within the policy can result in an increase of the after-tax yield of your cash reserves (also referred to as cash value). For example, if you are nearing a 50% tax bracket and your after-tax yield on interest is 4%, you would have had to earn 8% pre-tax. So the policy's tax advantaged treatment of investment interest is beneficial even in low-interest periods. Some of the GIC-type investments offered are also linked to the performance of certain market-driven indices.
A wide range of investment options. These policies can offer interest-bearing accounts over various terms. Many also offer side-funds that invest in stocks, bonds, and cash equivalents. Combined, these options help you match your specific goals with market conditions and your risk tolerance level. However, it is only the interest-bearing term deposits that are tax-advantaged.
The cost of insurance is paid with pre-tax dollars. The cost of insurance can eventually be paid from this interest-earning side-fund. Once enough money is held within the fund, over a long enough period, the cost of insurance is paid from some of these untaxed funds. Depending on the insurer, the insurance in the plan can be annual term, 10 year term, or term to age 100, or a combination of term periods. Premiums for this insurance relate to your age, health, and smoking status. The premium costs are initially calculated to pay for the insurance and to increase the reserve cash fund. This builds funds that can be used to prepay future ongoing premiums.
Flexible premium payments. You can pay what is referred to as a minimum premium. If you want to pre-fund the policy with more money, you may be able to increase your annual premium on a monthly, annual, or occasional (lump sum) basis, up to a specified maximum. A maximum premium is calculated and pre-set in order to keep your policy exempt from accrual taxation. Once your cash value increases, you may be able to reduce or skip premium payments altogether, without jeopardizing insurance coverage. Some policies may have a minimum annual premium for several years. A well-funded policy's money reserve (cash account) can continue to grow even as it pays for the cost of insurance. If you want to accelerate your tax-deferred interest savings, you may be able to increase premium payments. If you choose to select a limited-pay premium period, and interest rates are low, you may need to pay for several more years to compensate for the low interest rate. Conversely, if interest rates are high, you may be able to shorten your premium-paying period. Once you stop paying premiums, the insurance, administrative charges, and cost of any additional benefits and riders would continue to be paid (deducted) from your side-fund's reserve account value.
Add features from a list of riders and extra benefits. In some cases, term riders can be added to the policy, allowing for simple, low-cost insurance on the life of the insured and his or her children. Some policies provide a disability rider, which could provide income in the event that the owner is disabled. Additionally, a waiver of premium rider could possibly pay for premiums.
Assets are liquid and accessible
You can borrow against your cash account's reserves. The cash surrender value (CSV) is just another name for the remaining cash in the side fund. If you had $100,000 in that fund, you would be able to borrow against it or withdraw it with some potential taxation. If you cancel the policy later in life, you should receive most of this cash value. However, there may be taxes due on a portion of the funds when withdrawn or when the whole policy is cancelled. For this reason, a loan makes a lot of sense; it allows the funds to stay within the fund without accrual taxation, on reserve, while continuing to earn tax-free interest.
Funds are accessible. It is essential that such policies are well funded and that you monitor your cash reserves to avoid the cost of insurance overly reducing them (the cost of insurance can increase the older one gets). The tax-deferred funds can then grow to become a considerable liquid asset and result in an increase in your net worth. By carefully managing the cost of insurance (and perhaps reducing the insurance as the funds rise in value), you can minimize the reduction of the value of the tax-deferred account. Of course, you need to fund the policy sufficiently, always leaving enough money in the account to pay for the upcoming insurance premiums. If you withdraw too much money too early, there may be applicable taxes due, and a surrender fee may apply. Early withdrawal may reduce the functionality of the strategic advantage of tax accrual limitation, because any increasing insurance cost can deplete smaller reserves. Again the importance of monitoring the proper use of the policy by experienced tax and insurance planners is important. Often a computer program offered by the insurer can facilitate ongoing assessment as to the future cash increases in relation to the internal costs of the death benefit (cost of insurance, administration fees, riders, etc.)
The long-term effect is that you may be able to realize tax-advantaged investment growth that can outperform similar investments held in a taxable vehicle. Policies can allow for future withdrawals to provide for special financial needs, or additional retirement income. Premiums are always paid with after-tax dollars, so much of the fund is already tax-paid principal. This allows a good portion of any future withdrawals, in most cases, to be paid out tax-free. Moreover, the major benefit is that the entire death benefit including the cash value passes to the heirs tax free at death.
Special insurance laws govern this life insurance
Creditor protection of cash value. Special insurance laws may protect these policies from creditors, which could preserve the cash reserves if a business faced economic turmoil. However, a business owner cannot quickly hide money in a tax-deferred cash reserve if he or she knew there was potential bankruptcy looming on the horizon.
An excellent estate planning tool
The death benefit is adjustable. The amount of life insurance can be increased or decreased to reflect your changing needs. If the death benefit remains level, eventually the major portion of the benefit can over a long period of time, consist of the cash reserve (CSV); as the need for the insurance shrinks, the cash can increase (providing the insurance cost doesn’t reduce the cash value and its growth). If the death benefit grows, the cost of insurance will increase with age, and continues to be paid from the cash value.
Insured lives flexibility. You have the option of insuring yourself, your spouse, both of you, your children, or business associates using one or more of these policies. In some cases, the ownership can be transferred or lives added and the premiums paid from the original tax advantaged funds. Your death benefit can be payable after the first spouse's death to provide an income for the surviving spouse. Alternatively, you can arrange to have the benefit paid after the second spouse's death to maximize the value of your family's inheritance or meet your estate's tax liabilities.
Discuss the potential tax liability of your estate with a good tax advisor, CA, or investment advisor specializing in estate taxation. You may also want to seek counsel from an estate-planning lawyer. Make sure you, along with your investment advisor, assess the estate's need for life insurance and the various solutions. The best estate-planning solutions are most often insurance related because life insurance is designed to pay a large capital benefit at precisely the time it is needed.
The tax savings can pass tax-free to your beneficiaries. This offers an amazing estate planning advantage. With your first premium payment, you secure a substantial death benefit in relation to premiums paid. If you hold the policy for several years, you can begin to create tax-advantaged growth within the policy. With a growing cash fund, the insurance can be paid with pre-tax dollars. If the policy's cash value grows, your entire principal, plus untaxed interest, including the remaining life insurance value, pass totally tax-free to your heirs. Taxes can erode the value of a significant estate containing capital-gains investments such as stocks and bonds, equity mutual funds, the family cottage, a second residence, or business assets. Upon death, taxes will also be due on funds remaining in an RRSP/RRIF (after the death of both spouses in the case of a married couple). One policy can replace or pre-fund such taxes due. With a joint last-to-die policy, the insurance proceeds can be used to cover the estimated estate taxes. The advantage is that one's entire pre-tax estate valuation can pass, as desired, to the family heirs. What if these taxes can't be paid? The family may be forced to sell some cherished assets or to borrow to pay the tax bill. This tax planning can make family wishes come true.
Circumvent probate. When the tax-free benefit is paid directly to beneficiaries, there is no need to probate this money. In fact, other beneficiaries have no recourse to complain about monies paid to heirs in this manner. Depending on the province, probate legislation may be under review or currently changing.
Business-related estate planning
Protect your business assets. If you own a business and die, will your partners be able to pay for your share of the company? Why not insure your life, and the lives of the other partners and key employees? The death benefit of the policy can create immediate capital to take the business through the transition of losing one of its leaders, buy out the outstanding interests (share ownership) of the surviving partners, pay off creditors, or in the case of the key person, provide head-hunting monies to replace him or her.
Business owners can protect spouses. If a spouse who was not active in your company survives, chances are he or she would rather be paid cash for the value of their shares and leave the running of the business to the surviving children or partners. It is difficult for executors to make sure that a wife, for example, is paid enough money to live on if she continues to share ownership. In some cases, surviving spouses constantly need to be updated on the business's finances and performance, and all too often have issues getting their due income. An insurance policy could rid the executors of the responsibility of ensuring that the company's remaining owners pay the spouse.
The insurance benefit could be paid directly to the spouse or flow through the business or the business partners as per a pre-established buy-sell agreement.
Who is the tax-advantaged plan designed for? As with any life insurance policy, it is designed to pay beneficiaries a tax-free benefit upon the policy-owner's death. That is the main reason to buy such a life insurance policy. The taxation scenario is a great secondary benefit; but the main purpose should be to ensure that needs are covered by the life insurance component. It is ideal if you:
• plan to carry life insurance all your life;
• have considerable extra cash flow after you contribute to your RRSP;
• have a tax bracket approaching the highest level;
• have a desire to earn interest without taxation;
• may have a future tax liability in your estate;
• have a consistently good cash flow with excess money to invest;
• have good future business prospects for large profits and annual, recession-proof increases in your business valuation;
• desire to enhance RRIF income in retirement;
• desire to pass wealth to the next generation or to a charity; and
• have large loans that reduce your potential net worth.
Note: What are the administrative fees? First, you make deposits, similar to deposits made to a bank account. Then, just as your bank charges service fees to your account each month, the insurer subtracts charges to cover the various expenses in the policy associated with the cost of insurance, administration fees, policy fees, rider fees, etc. The account is then credited with any interest earned (this interest is without taxation while remaining in the plan). If you keep the policy long enough, some companies add a bonus percentile to the interest earned factor.
