Life insurance is a smart way to provide for your dependents after you pass away. If something happens to you, the life insurance policy will pay them a fixed amount of money to help cover their cost of living, clear debts, or pay final expenses.
Some life insurance policies include benefits beyond just death benefits. For example, permanent life insurance policies (like whole life and universal life insurance) combine lifetime coverage with a cash value (savings) component. The cash value grows tax-free at a fixed or variable rate and can be accessed for any purpose, like to supplement your retirement income or pay down a mortgage.
Is using life insurance as an investment tool a good idea? Continue reading to find out.
What are the types of life insurance with an investment component?
Whole life insurance and universal life insurance are two types of permanent life insurance plans that include a cash value component. Both use a part of the premium payments to cover the cost of insurance and administrative fees. The remainder is used to grow the cash value over time.
In the case of whole life insurance, the cash value grows at a predetermined rate set by the insurance company, and there is guaranteed death benefit. In contrast, universal life insurance has a variable cash value growth rate. Your cash value growth depends on the performance of the insurer’s investments.
Regardless of whether you buy whole life or universal life insurance, the cash value grows tax-deferred. This means that until you access it (e.g. borrow against it), there are no tax implications. The arrangement offers two tax benefits:
- Your cash value grows faster because it is not taxed up-front each year.
- If you access the cash value when you are in a lower tax bracket (for instance, after retirement), you will pay less income tax than when you were contributing the money to your account.
Once you accumulate cash value, you can access it at any time and for any purpose. For example, if you are buying a house, the policy's cash value can help pay for the down payment and closing costs.
You can access your cash value through a policy loan, a cash withdrawal, or cash surrender, with certain tax implications. The last option gives you access to all of the cash value that you have built up over the years — the cash surrender value. However, it will result in the termination of your coverage.
When is the best time to get whole life insurance?
The best time to buy whole life insurance is when you are still relatively young. That is because it usually takes 10-15 years for a whole life insurance policy to build enough cash value to be used.
Why life insurance is a good investment?
Here are four reasons why life insurance can be a good investment.
1. Permanent life insurance coverage
Life insurance needs are rarely one-size-fits-all. While most people prefer more affordable term life insurance, you may want a policy that doesn’t expire. For example, if you have a lifelong dependent, you might be better off with a life insurance policy that will pay out regardless of when you pass.
A permanent insurance plan may also be appropriate for someone who wishes to leave an inheritance to heirs or make a charitable bequest.
2. Tax-advantaged investing
Your policy’s cash value grows on a tax-deferred basis. If you have maxed out your RRSP and other tax-advantaged investment vehicles, buying a permanent life plan might be a good option. It could help you build a larger estate than you could with a taxable investment account.
3. Estate planning
The tax-free nature of the life insurance policy plays an important role in estate planning, especially if you have a large and complex estate. The death benefit can be used by your estate executor to cover probate costs, your final tax return, and various legal fees associated with estate distribution. Furthermore, life insurance can ensure that all of your heirs receive an equitable inheritance (estate equalization).
4. Access to cash value
Your policy’s cash value can provide access to funds when you need it, including when an unexpected expense comes up. Compared to traditional loans, policy loans have lower interest rates and do not require a credit check.
Why not get life insurance with an investment component?
A whole life and universal life insurance’s investment component is an extra feature, not the main attraction. The primary purpose of these policies is the same as of other types of life insurance plans: To provide your dependents with financial security after you’re gone.
For this reason, life insurance with cash value makes sense only if you also need permanent coverage. Even then, only consider it if you are relatively young or have exhausted traditional investment options.
Whole life or universal life insurance is likely to be not the best choice if:
- You need lifelong coverage but not a savings component: A term-to-100 life insurance policy is a better option. It provides permanent coverage without cash value. Hence, it is much cheaper than whole life or universal life insurance.
- You need life insurance for a limited number of years: Term life insurance is a good fit for people who need insurance coverage for a specific period of time. It is simpler and often much more affordable than permanent life insurance.
- You don’t need the insurance component: You should explore other types of investments first. Most other investment options (like an RRSP or mutual fund) give better returns.
- You are over 60: Generally, it takes several years of compound interest for cash value to grow significantly. So the benefits of the investment component might not be worth the cost if you are buying a whole life or universal life insurance policy later in life.
What are alternative ways to invest?
Consider a term life insurance policy if you need life insurance to protect your family's financial future but do not require the cash value component. It is easier to understand and often cheaper than whole life or universal life insurance. Instead of investing in an RRSP or a mutual fund, you can invest some of that money in life insurance.
Is life insurance for me?
Life insurance, which pays a death benefit when we pass away, seems like a good idea. But if you are young and healthy, you may be wondering if it is right for you. There is no one right answer. It all depends on your personal situation and financial goals.
Having said that, the easiest way to determine if you need life insurance to ask yourself one question: Would your death impact your family financially? If the answer is yes, you likely need life insurance.
So if your spouse relies on your income, or if you have minor children, you should get life insurance. The payout could help your family stay afloat should the unthinkable happen.
Those who have a large, complex estate can also benefit from life insurance. Life insurance proceeds may help to preserve the value of your estate and ensure that your heirs receive exactly what you intended.
Also consider life insurance if you own a small-business. The payout can assist your heirs or business partners in covering a variety of expenses, such as hiring additional help and funding a buy-sell agreement.
If you need lifelong insurance coverage and have exhausted your tax-advantaged accounts (ie. RRSP), purchasing life insurance as an investment may be an option.
In most other instances, you are likely better off purchasing term life insurance or a permanent life insurance policy with no cash value. You can invest the money you would save in a RRSP, mutual fund, or stocks, which usually provide better returns than life insurance.
Contact a financial advisor from Dundas Life to determine a suitable investment strategy.
Frequently Asked Questions
What tax advantages whole life insurance provides?
Permanent life insurance accumulates cash value and has the following three tax advantages:
- Life insurance proceeds are paid tax-free
Your beneficiaries do not have to pay tax on the death benefit they receive. With life insurance payouts often being quite large, tax-free savings could be significant.
- Cash value grows tax-deferred
The cash value account is tax-free while it is growing, which may allow you to accumulate more of it.
- Tap into the cash value on a tax-advantaged basis
You can borrow or withdraw money from the cash value up to the cost basis of the policy (the total amount you have paid into the policy) without paying income tax. For example, if you withdraw $20,000 from your cash value and your policy's cost basis is $17,000, you will receive a tax bill for $3,000 rather than $20,000.
How to qualify for life insurance?
The insurance company will assess your life expectancy before issuing you a policy. They make money from premium payments, so they estimate how long you will make payments before they pay out the death benefit.
Age, health, medical history, family medical history, gender, lifestyle, hobbies, and occupation are all factors considered by life insurance companies when determining your life expectancy. In general, the longer your expected lifespan, the less you end up paying.
If you are unable to qualify for a fully medically-underwritten term or permanent life insurance plan, consider simplified or guaranteed issue life insurance. These policies have less stringent health screening requirements, and can be a great option for those with underlying health conditions.