Friday, June 09, 2000

Universal life increases room for tax deferrals

Cover off your needs: Only use money you can do without for 10 years or more

Michael Kane

The Vancouver Sun

VANCOUVER - For many Canadians, the thought of maxing out their registered retirement savings plan is a joke. There always seem to be more pressing needs for their money when the contribution deadline comes around each year.

For a fortunate few, the problem is a lack of RRSP contribution room caused by diligent savings, a generous employer pension plan, or both.

Your unused contribution room is detailed on notices of assessment that are mailed out by Canada Customs & Revenue Agency.

If you find there is little room left but you still have excess cash, universal life insurance is another way to minimize the taxman's take. It is an option that allows you to defer and even avoid income taxes. That's because the savings portion of the policy is not taxed as long as it is paid out at death.

First, however, you must cover off your income-replacement needs. Generally, your best bet is through term insurance, a type of life insurance that will provide for your loved ones or business needs if you die during a specified term, typically 10 years at a time.

Universal life insurance comes into its own when you have built assets and you want permanent coverage, says Lyle Konner, a financial advisor based in White Rock, B.C.

Permanent insurance means you know where you stand on premiums, whereas term insurance can become prohibitively expensive as you age, and may be unobtainable if your health declines. Permanent insurance also has estate-planning advantages. Perhaps you want the tax-free proceeds of the policy to pay capital gains tax on a vacation property or an investment portfolio that you want to pass down to the children. A Universal life policy could ensure that your estate does not have to liquidate some or all of the assets to pay taxes.

The other key advantage is that a universal life policy lets you shelter money from tax over and above your RRSP limits. "You don't get a tax deduction when the money goes in but you have the same investment options, in funds or indexes, and it grows tax sheltered like your RRSP," Mr. Konner says.

"For those who are in a position of perhaps not having a lot of personal debt, have maxed out their RRSPs and have some excess cash, it is an alternative for diversification."

The policy has a life insurance component and an investment one. Since you can enjoy tax-free compounding on the investment portion, CCRA has imposed limits on how much you can contribute to that component of the plan. Much will depend on your age, but it can be as much as three times the cost of the life insurance. In many cases, the savings portion each year would be greater than the $13,500 RRSP contribution limit, more than doubling your capacity for tax-free compounding.

At your death, the entire amount, including the accumulated savings, will be paid to your beneficiaries without tax consequences.

This strategy makes less sense if you expect to draw against the cash value while you are alive. Then the amount you receive will be taxable, or partly taxable, depending on how long you have held the policy.

If you think that you will need to draw on your life insurance to supplement your retirement income, you might be better off with alternative investments, says Daniel Stronach, a personal financial planner in Toronto. This is because permanent life insurance is subject to extra fees and taxes that create a drag on your returns.

Mr. Konner says the investment portion should be funded with money that you can justifiably say you are prepared to put away for 10 years or more. "No matter what amount you are talking about, because of the charges built into an insurance contract, 10 years seems to be the magic number where the returns on the investment inside the contract start to exceed the returns you could earn on an investment outside the contract."

An additional benefit of universal life is once the investment account has been built up over several years, you can maintain the insurance coverage by allowing the insurer to draw down from the account to pay the premiums. "The premiums are effectively paid with pre-tax dollars," Mr. Konner says.

And, if the contract is structured properly, you can make tax-free withdrawals if you become disabled or develop a critical illness, although not all universal life policies include this benefit.

"I think that’s a feature that will become increasingly attractive," says Mr. Konner.

One more advantage of universal life is that investments can be switched inside the plan without attracting capital gains tax and there are no restrictions on foreign content.

Permanent life insurance contracts are very complicated investments and demand a long-term commitment, Mr. Stronach says. So, take your time before you sign.

Mr. Stronach adds these cautions:

• Don’t buy permanent life insurance based on your current cash flow. It makes sense to have a clear understanding of why you will need permanent life insurance and how much. An independent financial plan will help you clarify your options.
• Situations change. What is happening in your life today may not apply two years from now. Understand what you can do and how it will affect you if you do not have the same needs in the future.
• Life insurance contracts are front-end loaded. So, if you change you mind in the first few years, you can lose most of your investment.
• Be wary of projections. Always consider the worst-case scenario as well as the expected. Ask for projections at 4%, 6% and 8%. Although projections may indicate your policy will be paid up in 10 years, if the returns are not achieved, you may have to continue making payments.