You get a unique combination of benefits with life insurance, especially as a business owner
When you think about life insurance, you are likely thinking about temporary (“term”) life insurance to satisfy your current protection needs. The premiums look like an expense to be minimized and stopped as soon as possible. The premiums look low because your chances of dying are low.
With permanent life insurance, you are creating an asset. Your premiums are an investment and often come from savings or the sale of low-yield taxable investments like Guaranteed Investment Accounts (GICs) or bonds. The premiums are higher because the probability of a payout is 100% if you keep the coverage for life.
Here we look at the advantages of life insurance, whether temporary or permanent.
The taxation of life insurance
With life insurance, you fund your premiums with after-tax dollars, and your beneficiaries receive a tax-free death benefit. That’s a good combination.
Clients ask how to make their premiums tax deductible. They can often make a portion called the Net Cost of Pure Insurance (NCPI) deductible by leveraging life insurance to invest (which can also make the loan interest tax deductible). One such strategy is an Immediate Financing Arrangement (IFA).
If your life insurance premiums were tax deductible, your death benefit would likely be taxable. That’s generally a worse outcome because the death benefit is much larger than the premiums (especially with temporary life insurance and if death occurs in the early years).
Life insurance for needs
You likely have needs like:
- Paying off a mortgage
- Providing for dependent family members
Temporary (term”) life insurance provides tax-free cash at death. You are creating an estate. The premiums look low relative to the death benefit because the probability of you dying during the coverage period — often 10, 20 or 30 years — is low.
Term life insurance tends to get cancelled well before a payout for several reasons:
- Self-sufficiency: Your needs generally decrease as your family gets older and your assets grow
- Affordability: Your premiums generally increase sharply each 10, 30 or 30 years sharply
- Product design: Coverage usually ends automatically when you are age 75 or 80
Most temporary life insurance plans allow you to convert some or all of your coverage to permanent life insurance regardless of your health. Your new premiums are based on your age at the time of conversion (called your “attained age”). The maximum conversion age is shown in your insurance policy and is generally between 70 and 75.
Life insurance for wants
Since the need for insurance tends to decrease with age, why would anyone want permanent life insurance? As you grow older, you have likely accumulated wealth. Your focus likely turns towards preserving this wealth for your heirs and charities.
There is a problem: you are taxed on investment income, dividends and realized capital gains. You can defer the tax on investments like real estate and publicly-traded securities by not selling them. However, at death, there is a deemed disposition: you are taxed as if you:
- Sold all your assets the day before you died
- Redeemed your entire RRSP or RRIF
Spouses often transfer assets to each other at death. While this transfer is generally tax-free, the big tax liability simply gets deferred to the time the surviving spouse dies.
In a sense, you don’t have a problem because you have assets that can be sold to pay the tax bill. Does that make paying taxes feel better?
How permanent life insurance helps
Permanent life insurance helps you in several ways:
- Tax-free death benefit: the same treatment as with temporary life insurance.
- Tax-sheltered investment growth: you are not taxed on the annual growth in the savings inside your whole life or universal life insurance policy. The benefits are so valuable that the tax rules restrict:
- How much you can deposit: limited by the Maximum Tax Actuarial Reserve (MTAR).
- The maximum permissible growth: penalized by the “8% rule”.
- The timing of your deposits: affected by the “250% test”.
- Tax-free access to the cash value: you can access the cash value by leveraging your life insurance. That means taking a loan secured by using the cash value as collateral. With an insured retirement plan, the lender may even allow the loan interest to be added to your loan balance and eventually paid from the tax-free death benefit.
- Quick liquidity: the death benefit is usually paid within weeks of receiving the completed paperwork. Compare that with the lengthy process of probating a will and settling an estate.
- Attractive after-tax rate of return on death benefit: compared with fixed-income assets like Guaranteed Investment Certificates (GICs) and bonds, the after-tax returns later in life may be higher. If death occurs in the early years, few investments can match the rate of return (often thousands of percent in year one, for example).
Why not get term life insurance instead?
Temporary coverage often expires before you die. That’s why the solution for wants is permanent life insurance. Yes, the premiums are higher, but the death benefit will get paid one day and grows with proper structuring.
In contrast, temporary life insurance is more of a gamble because the death benefit is rarely paid out. Also, the value of the death benefit drops in real terms because of inflation.
The additional benefits of corporate-owned life insurance
If you have a private corporation — a Canadian-Controlled Private Corporation (CCPC) — you face additional tax challenges that life insurance can help address:
- Tax on passive investment income: the cash value in life insurance grows tax-sheltered
- The grind down of the Small Business Deduction limit: as your investment income grows above $50,000 in a year, more of your active business income gets exposed to a higher tax rate. That doesn’t happen with life insurance.
- Tax on assets removed from your corporation: whether you take a salary or shareholder dividends, you are taxed on what you receive. Instead, you could access the cash value in corporately-owned life insurance personally via tax-free loans (called a corporate insured retirement plan). Since you are using a corporate asset for personal benefit, your accountant may advise you to pay your corporation a guarantee fee.
- Taxable shareholder dividends: the life insurance death benefit above the Adjusted Cost Basis (ACB) gets credited to the corporation’s Capital Dividend Account (CDA), which allows tax-free capital dividends to shareholders (your heirs).
Explore the tax advantages of life insurance for yourself
Life insurance does much more than provide protection. We are here to help by preparing and explaining scenarios specific to your own situation. To get clarity from your family team at Taxevity, schedule a chat.