If you are a business owner, you may be wondering: Can I use life insurance for investment purposes?
The short answer is, yes.
Life insurance and corporate investing often go hand in hand for small or medium-sized business owners. A corporate-owned life insurance policy can lead to substantial savings on insurance premiums over time, provide access to liquidity, make it easier to get a business loan, and help transfer the death benefit to the your estate as a tax-free capital dividend.
Continue reading to find out how to use life insurance inside a corporation as a tool to accumulate wealth.
What is life insurance?
Life insurance is a financial product that pays a cash benefit, typically as a lump sum, to your beneficiary upon your death. Broadly speaking, life insurance plans fall into two categories: term life insurance and permanent life insurance.
Term Life Insurance
Often referred as the purest form of life insurance, term life has only one goal: to provide your loved ones with a financial safety net in the event of your demise. Term life plans last a specific period, which can be as short as one year or as long as 30 or 35 years. When this period ends, the coverage terminates, unless you renew the policy or convert it to permanent life insurance. Term life insurance doesn’t accumulate wealth and on average is 5-15 times more affordable than permanent life.
Permanent Life Insurance
With a permanent life policy, you get lifelong insurance protection. These types of insurance policies also include a savings component, called the cash value. You can borrow money against your policy’s cash value or withdraw it, either partially or fully, at any time while you are still alive.
Only permanent life policies that build cash value can be used for investment purposes. You can use such a policy to diversify your investment portfolio, supplement qualified retirement savings vehicles, like an RRSP, or to save for a future expense, like a down payment.
Pros and cons of permanent life insurance?
Permanent life insurance has its benefits, like lifetime coverage and cash value. But it is not the right type of policy for everyone. Knowing about its pros and cons can help you decide if it fits your long-term financial goals.
- Tax-deferred growth
The main purpose of life insurance is to provide a cash benefit to your family when you pass. Permanent life policies do that and can also become an asset over time. These plans come with an investment component that gives you an opportunity to accumulate wealth on a tax deferred basis.
Tax-deferred growth means you will not pay tax on any interest or investment gains on the cash value until you withdraw it. This arrangement offers two main benefits:
- Your cash value grows faster since tax is not deducted from the interest or investment gains every year
- Withdrawing your money when you are in a lower tax bracket will result in a lower tax bill
You can access the cash value at any time and for any purpose. But keep in mind there may be tax consequences. Specifically speaking, the part of the borrowed or withdrawn amount that exceeds the policy’s adjusted cost basis (ACB) is subject to taxation. For example, if your policy’s ACB is $10,000 and you withdraw $12,000 from the cash value, you will pay tax on $2,000.
- Lifelong coverage
Permanent life policies do not have an expiry date. While not everyone needs life insurance throughout their entire lives, some do. If you have a disabled child or want to leave a financial legacy, you may want to look at a policy that pays out regardless of when you die. The guaranteed payout feature also makes permanent life insurance a good fit for those who want to use life insurance for estate planning or a buy-sell agreement.
Life insurance needs may change with time. If you think there’s a chance you will need more or less coverage than what you need today, universal life insurance (a subtype of permanent life insurance) may be right for you. Some universal life plans allow you to adjust the death benefit, within limits, as your insurance needs change.
- Potential to earn dividends
Some permanent life insurance plans gives you the opportunity to earn annual dividends, which you can use in different ways. You can invest them in the built-in investment account to accumulate wealth more quickly. Or you can use this money to purchase more coverage or pay off the premium.
- Higher cost
The biggest downside of permanent life insurance is its high cost. Expect to pay anywhere between 5 to 15 times more than a comparable term life plan.
- Cash value grows gradually
In general, cash value takes several years to grow to a meaningful amount.
- Safer investment returns
The return rate on the cash value is pretty moderate. For instance, whole life plans typically offer an annual return rate of 1% to 3.5%. You will likely be able to get better yields from other investment vehicles, such as mutual funds, stocks, and bonds.
- Cash value withdrawal isn’t free
If you take out a policy loan, you are expected to pay it back with interest. Otherwise, the insurer will deduct the principal amount and interest from the death benefit. Withdrawing the cash value allows you to escape this penalty, but the death benefit will get reduced by the amount you withdraw.
What is corporate-owned life insurance?
Corporate-owned life insurance is exactly what the name suggests — a life insurance policy owned by a corporation. Typically, the insured is a business owner or partner, a senior executive, or any other employee vital for the company’s success. The company is both the policy owner and the beneficiary, meaning it is responsible for paying the premiums and receives the policy proceeds upon the insured’s death.
The corporation can use the death benefit to pay for the cost of replacing the deceased employee, fund a buy-sell agreement, or transfer most (if not all) of the proceeds to deceased’s estate as a tax-free capital dividend. Additionally, a corporate-owned life insurance policy can also serve as loan collateral when the company needs to raise capital.
What are the tax benefits of Corporate owned insurance?
Owning life insurance within a corporation provides several tax benefits, such as:
- Cheaper after-tax premiums
Corporations usually have a lower tax rate than individuals. The cost to fund a policy will be much lower when the premiums are paid with corporate dollars rather than after-tax personal dollars. This means you can purchase more coverage with the same cash flow using corporate dollars.
For example: Let’s say Martha owns a Canadian Controlled Private Corporation (CPCC) and is interested in taking out a life insurance plan with a monthly premium of $500. Her personal marginal rate and corporate tax rate are 50% and 10%, respectively. If Martha were to purchase the policy personally, she would need $1,000 a month.
Whereas, if she buys the same policy through her corporation, her monthly cost would only be around $555. This means that a corporate-owned policy will save Martha roughly $445 a month.
- Tax Advantages of the death benefit
The part of the death benefit that exceeds the policy’s cost basis can be paid tax-free to a shareholder or the deceased’s estate as a capital dividend.
- Tax-deferred cash value growth
The cash value of a corporate-owned life insurance policy grows tax-free. The corporation can access it at any time or use it as collateral for a business loan. Assigning a corporate-owned life insurance policy as loan collateral may also make you eligible for a tax credit.
Who can use corporate owned life insurance?
Corporate-owned life insurance can be a good fit for professionals with their own practices, like dentists or doctors. It can also provide important benefits to small- and medium-sized business owners.
Curious to see if insurance is a smart investment strategy for you? Reach out to a Dundas Life licensed advisor today. We specialize in helping business owners and high-net worth individuals with insurance and estate planning.
Frequently Asked Questions
Is life insurance a good investment?
The primary purpose of life insurance is to provide financial protection to your dependents after you pass. Using it solely for investment doesn’t make sense since other investment vehicles typically offer far better returns.
That said, high-net-worth individuals who need life insurance protection may find the investment component of a permanent life policy to their liking, particularly if they want to diversify their portfolio or have already maxed out traditional retirement savings accounts, like the RRSP.
What are the benefits of owning a policy within a corporation?
Owning a life insurance policy within a corporation has three main tax benefits:
- The cost of owning a policy is much lower when premiums are paid by a corporation rather than an individual
- The cash value grows tax-free until withdrawn
- A considerable portion (if not all) of the death benefit can be passed to deceased’s estate or the surviving shareholders in the form of capital dividends