As the number of tax strategies continue to dwindle, life insurance has stepped up to the plate as an attractive option to defer and even avoid income taxes. This is mainly because the savings portion of the plan is not taxed as long as it is paid out as a death benefit. So, you can direct your extra cash flow (or assets) into a policy and it will compound tax free. And upon your death, the entire amount (including the accumulated savings) will be paid to your beneficiaries without any tax consequences.

This strategy makes good sense if you don’t expect to need the money in the future. But if you draw against your cash value while you are alive, the amount you receive will be taxable or partly taxable depending on how long you have held the policy.

Therefore, if you expect that you will need to draw on your life insurance to supplement your retirement income, you might be better off with alternative investments. This is because with permanent life insurance there are extra fees and taxes that create a drag on your investment results.

If you can safely assume that the accumulated savings in the life insurance plan are destined to be paid out to your beneficiaries on death, the tax-free compounding generally outweighs these extra fees and taxes.

Universal Life enables you to separate the life insurance component from the investment component. With many recent policies, the investment component offers you a number of options (i.e., Toronto 35 Index, TSE 100 Index, S&P 500 Index, as well as a variety of fixed income options).

Since you can enjoy tax-free compounding on the investment portion, Revenue Canada has imposed limits on how much you can contribute. In the case of Dr. Green (below), his minimum premium was $7,521 and his maximum was $34,706 – so he could allocate as much as $27,185 into savings.

If you view both the life insurance component and the investment component as separate investments, the profitability of the life insurance component depends on when you die. To determine your profitability, you must consider how much you invest and how much you get back.

So, if Dr. Green died after 10 years, he would have invested $7,521 per year for 10 years and his beneficiaries would receive $1,000,000. They would have enjoyed an annual compound rate of return of 45.52% and this is after-tax (see Chart 1). Naturally, they likely wouldn’t appreciate the return, given the circumstances, but there is an investment consideration with pure life insurance. (Note: The longer you live, the lower your investment return.)

The investment portion of the Universal Life policy naturally depends on how well your investments perform. If you earn 6%, you will earn 6% and will not have to pay tax on this growth (unless you draw on the cash value prematurely).

However, if you think the rate of return outside your life insurance plan will be the same as that inside your insurance plan, you’re in for a rude awakening. A Universal Life policy which allows you to invest in the TSE 100 may actually credit your plan with the change in the TSE 100 Total Return Index less 3%. Or the insurance company may credit your plan with the change in the TSE 100 Stock Price Index – which excludes dividends of about 3%. And for those who elect to peg your return with Government of Canada securities, you may actually earn 90% of the yield on Government of Canada securities less 1 ¾%.

Each company has a different twist on what they actually credit your account with. It is not like investing in an indexed mutual fund. The insurance company will credit your account with a return based on their formula. So make sure you understand the formula, as the variance may be very large.

This spread is comprised of policy fees, a special income tax on savings inside insurance plans (IIT), and the insurance company’s own investment management fees.

However, in spite of the extra fees and taxes, if the money remains in the plan, the benefits of tax free compounding will generally outperform conventional investments. The table below illustrates the rates of return you would have to achieve before-tax to obtain the same results after-tax. For example, if you earn 6% inside your Universal Life Policy, you would have to earn 12.05% in interest, or 9.08% as a dividend, or 9.63% as a capital gain.

Actual	Equivalent Before-Tax
After-Tax	Interest	Dividend	Capital Gain
4%	8.03%	6.05%	6.42%
5%	10.04%	7.56%	8.06%
6%	12.05%	9.08%	9.63%
7%	14.06%	10.59%	11.24%

Dr. Green, a 45-year-old, has purchased a Universal Life insurance policy which will pay his estate $1,000,000 on his death. It has been established that Dr. Green has a life insurance need of $1,000,000 but with other financial obligations, he does not have extra cash to put aside for his estate. Therefore he has elected to pay the minimum ($7,521 annually) – which is basically the same amount that he would pay for "Level Term-to-100".

Ten years later, at age 55, Dr. Green has a detailed financial plan prepared for him which indicates that at his current rate of savings and given his long-term plans, he will accumulate more cash than he needs to maintain his lifestyle indefinitely. Therefore with consultation it is decided that over the next 10 years (age 55 to 65) he will allocate $150,000 of his savings to his existing life insurance policy ($15,000 annually for 10 years). (See Chart 2)

By committing these extra funds to his life insurance policy, he now has more options available:

For Dr. Green, selecting Universal Life may be a more favourable solution than Term insurance mainly because as his financial situation changes, he can use his existing policy for different reasons. At 45, his life insurance will be necessary to replace his income and eliminate his family debts, while at 65, his life insurance may be beneficial to enhance the value of his estate. By maintaining his original policy, his pure insurance costs will be much lower than if he were to replace his policy at age 55 or 60. Also, there is the risk that he wouldn’t qualify for insurance.

A proper financial plan at 55 provided Dr. Green with a clear understanding of his long-term picture. Therefore he was able to improve his estate plan by making use of an existing inexpensive vehicle.

If Dr. Green’s financial plan did not clearly indicate a projected surplus of assets, then his current and future insurance needs would have to be re-evaluated. And with most Universal Life policies, he will likely be able to work with his existing policy to improve his outcome.

Universal Life insurance can also work for those who are further along in life. For example, at 65 Dr. Black just retired from practice and had a financial plan prepared. His financial plan revealed that he has more investment assets than he needs to maintain his lifestyle to age 100. Up to this point he has always bought term insurance to cover his needs. Although he may not need permanent life insurance, he can enhance the value of his estate by acquiring a policy on a "Joint-and-Last-to-Die" basis. This way Dr. Black and Mrs. Black (also 65) will be insured together so that the death benefit will be paid on the death of the surviving spouse. By combining the two lives, the result will be a lower age factor in determining the cost of insurance – thus the insurance costs will be minimized.

In the case of Dr. and Mrs. Black, they decided that they would allocate $250,000 to their estate, so they invested $50,000 per year for 5 years in a Universal Life policy. (See Chart 3)

(Note: Option 1 assumes a higher savings portion and a lower life insurance component than Option 2 – the result being a lower return in earlier years, but a higher return in later years. The rate of return assumes that the surviving spouse dies in that year. Therefore, given the premiums paid and the payout, the annual compound rate of return would be that rate.)

Naturally, the projections indicate that the shorter their lifespan, the greater the return on their investment. But it appears that even if they live to a ripe old age, to match their return using conventional investments they would have to earn about 6% annually after-tax. That’s about 12% per year before tax!

In addition to the financial benefits from the life insurance, by allocating a portion of their savings to this policy, they will reduce their current income taxes due to the reduction of investment income. This can sometimes reduce the extent of OAS Clawback.

Leveraged Life Insurance Program

Since Universal Life is much more attractive to those whose financial plans clearly indicate a projected surplus of assets, numerous schemes have been hatched to get more investors over that threshold.

Rather than limiting Universal Life to those who are well enough off to designate part of their net worth to their estates, Leveraged Life has been created to enable the investor to receive a retirement cash flow without the tax consequences.

Leveraged Life requires that you borrow against the cash value of your Universal Life policy such that the amount borrowed represents your income stream. Therefore, each payment to you results in an increase in your loan amount. And, as you do not make payments on this loan, each interest charge also increases your loan amount. This is called a "Capitalized Loan" and Chart 4 illustrates how the loan grows exponentially:

(Assuming a monthly payment of $3,000 and an interest expense of 8%.)

Leveraged Life looks very attractive on paper but as the loan grows exponentially, it is very sensitive to interest rate changes. And you must expect that the bank will be very jittery if investment returns and interest rates are not as projected.

So if you are considering this scheme as a partial solution in your retirement plan, tread softly and delay the payments for as long as you can.

Should you wish to discuss your insurance or financial planning without the pressure to buy, please call me at (416) 497-3590 or toll-free at 1-800-377-4761. Or press the Back link at the bottom of this page to fill out the response form.