The individuals who may gain the most from Universal Life are those who:
• plan to carry life insurance all your life;
• have considerable extra cash flow after you contribute to your Registered Retirement Savings Plan (RRSP) and (Tax Free Savings Accounts) TFSAs;
• 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, increasing business valuation and capital gains;
• 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.
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.
There are several reasons why people use Universal Life (UL) for estate planning.
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, over a long period of time, can 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.
You can insure more than one life in the plan. 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.
UL works to protect you from the potential tax liability of your estate. Discuss your estate use of UL with a good tax advisor, CA, or financial advisor specializing in estate taxation. You may also want to seek counsel from an estate-planning lawyer. Make sure you, along with your financial representative, 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.
Mitigate tax erosion of the value of a significant estate. If you own stocks and bonds, equity investment funds, a family cottage, a second residence, or business assets you may face capital gains taxation in your estate. 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.
Circumvent probate and/or estate administration tax (EAT). When the tax-free benefit is paid directly to beneficiaries, there is no need to probate this money or have it reviewed by the government. In fact, other beneficiaries have no recourse to complain about monies paid to heirs in this manner. Depending on the province, such legislation may be under review or currently changing.
Business owners can protect their asset value. The death benefit of a UL policy can create immediate capital to take a business through the transition of losing one of its leaders, or key employees, while allowing surviving partners to buy out the outstanding interests via a payout of the share ownership of the deceased partner. This is commonly done within the framework of a well structured buy-sell agreement.
Other tax advantages. A UL policy owner can earn and accumulate tax deferred interest to potentially increase the after-tax yield of your investments and policy cash value over the long term. The UL deposits are protected from secondary annual taxation on interest earnings until withdrawn.
Universal Life strategies can help business related estate planning in these ways:
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, while allowing surviving partners to buy out the outstanding interests (payout share ownership of the deceased partner, using a buy-sell agreement), 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.
When you purchase a Universal Life policy you have certain amount of flexibility and accessibility to your money.
• Premium payments are flexible. 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, while the cost of the premium (insurance, administrative charges, any additional benefits, and riders) is eventually paid from within the plan. A well-funded policy’s money reserve (cash account) can continue to grow even as it pays for the cost of insurance.
• Borrow against cash account’s reserves. The cash surrender value (CSV) is just another name for the remaining cash in the policy. For example, if you had $100,000 in a policy’s tax-exempt fund, you would be able to borrow against it or withdraw it with some potential taxation.
With a permanent Universal Life Insurance (UL) policy, there are many options and tax advantages available within the plan. Death benefits may vary, funds can be invested in tax-sheltered accounts, cost and types of insurance can be manipulated – all to the benefit of the consumer’s goals! What are the primary benefits of Universal Life (UL) for Estate Planning? The options abound:
• The death benefit is adjustable. The amount of life insurance can be increased or decreased to reflect an insured’s changing needs, and there are multiple options available when creating a plan. Typically, a person will choose an increasing death benefit that will pay out all life proceeds as well as any cash in the plan at time of death. Or, a person could choose a plan that pays out the death benefit as well as all premiums paid into the plan. This option ensures that family assets will not be eroded due to premium payments for the life insurance policy. A person may also choose a level death benefit, however the advantages of this structure are limited. Or, if a person eventually is insured, or does not require their current amount of insurance on their policy, they can simply reduce the death benefit. In the end, a policy’s death benefit can be structured to suit the needs and goals of the insured.
• Insure multiple lives in a UL plan Several lives can be insured or added to one plan, including a spouse and children. Business associates may also be named as multiple insured’s on a business policy.
• Special riders can be added In some cases, term riders can be added to the policy, allowing for a structured policy that addresses insurance needs now and in the future. For example, you can structure a policy with permanent Universal Life insurance as a base amount, then add a Term 10 or Term 20 rider.
• Disability riders can be added Policies may provide a disability rider called a waiver of premium. Upon disability, the policy premium can be waived until such a time as the person is no longer disabled.
• Create capitalized income for a surviving spouse Life insurance proceeds can be structured as an annuity, thereby providing lifetime income for the surviving spouse.
• Capital creation can be deferred Alternatively you can arrange to have the death benefit paid after the second spouse’s death to maximize the value of your family’s inheritance or meet your estate’s tax liabilities. These policies are typically called Joint Last to Die policies.
There are many compelling reasons to combine your investments in a tax-advantaged life insurance policy. Tax advisors have been pointing their wealthier clients to these unique policies for years. Let’s examine some of the tax benefits, investment options, overall features, and for whom they are best suited. Depending on the insurer, there can be many possible options, but all enjoy some of the following essential elements.
You can earn and accumulate tax-deferred interest. A tax deferral aspect of the policy allows that you may effectively increase the after-tax yield of your investments and policy cash value over the long term. The fund from which the cost of internal cost of insurance offers interest-bearing accounts over various term periods. Comparatively for example, if you are nearing a 50% tax bracket and your after-tax yield on interest-bearing term deposits is a low 2.5%, you would have to earn 5% pre-tax. The UL deposits conversely are protected from secondary annual taxation on interest earnings until taken out.
The tax savings can pass tax-free to your beneficiaries. This offers an 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. 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.
The cost of insurance is paid with pre-tax dollars. The cost of insurance can eventually be paid from this growing interest-earning side-fund. Once enough money is held within the fund, over a long period, the cost of insurance is paid from some of these untaxed monies. Depending on the insurer, the insurance in the plan can be an 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 designed to build funds that can be used to prepay future ongoing premiums.
The premium payments are flexible. 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.
The premium payment periods are flexible. 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.
There are additional 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.
There is potential creditor protection on the 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.
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, alternatively, a loan against the cash value may make more sense; which would allow the money 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. While funding the policy sufficiently you continue to pay for the upcoming insurance premiums with pre-tax dollars
The tax deferral is a long term strategy. 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 because any increasing insurance cost can deplete smaller reserves.
The long-term benefit is the potential tax-advantaged investment growth that can outperform similar investments held in a taxable interest bearing 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 from the fund (which includes the initial tax-paid principal used to make deposits). 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 heir’s tax-free at death.
Talk to your advisor about any legislation changes that may affect taxation.
There are specific life insurance policies offered with attractive tax-planning advantages. Legal tax-exempt rights are allowed in our tax legislation with life insurers, enabling the possibility to accomplish the following.
Premiums over and above the associated costs of insurance and premium tax are invested and can accumulate tax-deferred within specific plans.
Tax-deferral of the investments continue until such time that withdrawals are taken out from the policy.
Tax is avoided on both the face amount of the insurance and any ongoing cash accumulation in the policy when paid out to the beneficiaries on the insured’s death.
Taxation details. Most of the cash received from a life insurance contract is not subject to income tax. 1 Your beneficiaries — spouse, children, grandchildren or other beneficiary allocated will not need to report life insurance benefit proceeds on their tax return as taxable income. However, if you have assigned your estate as the beneficiary, the death benefit could be subject to tax. Moreover, fiscal gifts or inheritances generally are not taxable.
Beneficiaries or heirs do not owe estate inheritance tax or death tax. It is the estate of the deceased that pays any such tax due to the government. If the policy owner’s estate is the policy’s beneficiary, the death benefit may — in some cases be subject to tax. 2
When could a taxable situation arise?
When you own a permanent life insurance policy, accumulating interest or equity investments made to a policy’s cash value, taxes will be payable on that growth gained above the cost base of money invested. 3
Upon your beneficiaries receiving any investment earnings from the policy, along with a death benefit, the increase on investments, not the death benefit, would be taxable as income.
Likewise, you will pay taxes on any increase in cash value based on the investments in the policy fund — should you surrender the policy and receive its cash value in return.
Tax Reporting Rules for Life Insurance Payouts
The Canadian Revenue Agency (CRA) makes receiving life insurance proceeds easy for beneficiaries relative to tax reporting. Unless the tax is due on the above-stated earnings, these amounts do not need reporting as taxable income on a tax return.
What if there is an increase in the cash value?
These amounts don’t need reporting as taxable income on a tax return unless some tax is due on interest earnings. If there are interest earnings, it will be reported to the beneficiary by the insurance company on a T5 slip, reportable on line 121 of the beneficiary’s return (or of the policy owner when surrendering the cash value of the policy). 4
Here are some uses within an estate:
Final tax liabilities in an estate such as on capital property or the remaining RRSP/RRIF value is taxed fully as income and can be pre-funded.
In some cases, tax-exempt plans are used as a pledge to secure a loan to create additional cash flow in retirement. Cash resulting from a loan is not taxable. Where the loan is later paid from the death benefit, payment can be deferred until death. Repayment of the loan is thus partly repaid using pre-taxed dollars.
Others may borrow directly from their policy subject to the policy terms.
There are several different types of permanent insurance some of which policies are similar.
Whole Life, also called “ordinary life insurance”.
This traditional permanent life insurance will cover the insured for his/her entire (whole) life. The premium payments generally remain the same for the life of the insured.
Variable Life. This permanent life insurance policy offers a fixed premium payment schedule (like whole life), while it accumulates a cash value account offering other non-guaranteed accounts which invest in securities, with the associated risk of the stock market (portfolio performance can fluctuate either positively of negatively).
Universal Life (UL). This plan offers more flexibility than traditional whole life insurance. Universal life insurance allows the policy owner increased flexibility to pay premiums on a flexible basis, versus a fixed schedule. However, a certain level of premiums must be paid into the policy to cover the costs associated with the insurance coverage. Failing to do so may cause the insurance policy to lapse. Flexible tax-deferred interest rates on the policy’s cash value (some have guaranteed interest rates) add to the appeal of a Universal Life policy.
Indexed Universal Life Insurance. This coverage provides a death benefit, with tax-deferred growth on your cash value account which is indexed to one or more stock market indices. Many allow for a guaranteed minimum interest rate to protect the policy owner against the odds of a market downturn.
Variable Universal Life (VUL). Blending the premium payment flexibility benefits of universal life insurance with an invested portfolio with the upside market potential of variable life, many VUL policies feature tax-deferred earnings. Allowed policy withdrawals and loans from the policy cash value (which will reduce the cash value and death benefit) are subject to interest charges. Like variable life insurance, VUL policies are designed to invest primarily in securities with the upside potential to grow the policy’s cash value, with the associated market risk of losing money. Purchasing the right life insurance is an important strategic decision as you aim for financial independence.
If you have a spouse or children, make sure you have adequate life insurance coverage.
There are two types of life insurance. You can either buy pure term insurance coverage or a plan that can last a lifetime with various investment vehicles that can gain value and enjoy tax advantages while the policy remains in force.
Lifetime plans can resolve estate-planning problems. With additional investment vehicles (some include the use of the life company’s dividends) the cost of lifetime insurance coverage is higher. Yet the tax-free death benefit can solve estate-planning problems such as paying an estate’s tax liability on capital gains.
Life insurance is generally affordable. If you can’t afford the premium for lifetime coverage, consider term insurance or a combination of both. Term plans are quite affordable. For example, at 3%, $1,000,000 will generate $30,000 annual interest as pre-tax income.
Buy enough insurance to meet your needs. Many families need $250,000 or more—even up to $1,000,000 during low-interest periods—to generate adequate investment income if the breadwinner were to die.
Ask your insurance representative to do a capital needs analysis. You will want to replace the income of the life insured—either yourself or your spouse. It is easy to calculate the capital needed over any short or long period of time in any situation if the life insured were to die.
Buy the insurance you need when you are healthy. If you get high blood pressure or diabetes or suffer from angina before you buy insurance, you may find that your premiums will be higher than for a healthy person. So buy as much as you can afford when you are younger, and healthier if you have capital needs in relation to your dependents.