Life insurance is an important tool to help your family deal with the financial impact of your passing.
Certain policies, however, provide benefits to you, the policy owner. These policies combine death benefits with cash value that you can access at any time and for any reason, including as meeting a financial emergency, making a down payment on a house, or funding your retirement.
Keep reading to find out how you can use life insurance to build wealth.
Term vs. Permanent Life Insurance
Life insurance policies are of two types: term life insurance and permanent life insurance. Even though term life and permanent plans share many similarities — guaranteed death benefits and level premiums to name two — there are key differences. Knowing about them can help you determine which one of them is right for your family.
Term Life Insurance
Term life insurance comes with an expiry date. Your policy lasts a specific period chosen by you at the time of purchase. Term life insurance generally comes in 10, 20, or 30-year lengths, but some policies last until you reach a certain age, like 65. Your beneficiary is eligible for a payment only in the years when the policy is active, meaning if you outlive the policy term, your loved ones will not get the death benefit.
As your term life policy approaches the ends of its term, you will likely have three options:
- Let the policy lapse
- Renew the plan
- Convert it to permanent life insurance
You do not have to provide proof of insurability to renew a term life policy, though the renewal premium rate will be much higher than the original rate because of age. Converting an active term life plan to permanent life insurance also doesn’t require medical underwriting as long as the insurer is the same. This feature is a good option for those who want assurance that their family will eventually receive the death benefit.
Term life insurance does not build wealth, as it lacks a savings element. This means you will not receive a payment when you cancel your policy, nor can you take a loan against it.
Permanent Life Insurance
True to its name, permanent life insurance lasts as long as you do (of course, provided you pay the premiums). Permanent life insurance typically combines lifetime coverage with a savings element — called cash value. As such it is an option for anyone who wants to use life insurance to build wealth.
Your policy’s cash value accrues interest or investment gains and grows tax-deferred. You can access the cash value at any time and use the funds as you like. While the policy’s death benefit goes to the beneficiary, cash value is meant for you, the policy owner. Typically, any unused cash value at the time of policyholder’s death reverts to the insurance carrier.
Permanent life insurance coverage comes in two main types:
1. Whole life insurance
Alongside a guaranteed death benefit, whole life insurance promises a guaranteed rate of return on the savings. These policies can either be non-participating (i.e. no opportunity to earn dividends) or participating (you may receive annual dividends, depending on the insurer’s performance).
2. Universal life insurance
Like whole life insurance, universal life plans provide tax-free growth while you’re alive and a tax-free lump-sum payment to your family when you pass. However, these policies accrue cash value differently than whole life plans. The cash value grows at a variable rate, depending on the performance of the investment sub-accounts handpicked by you. Some universal life policies also give you the freedom to raise or lower your premiums and adjust the death benefit, within limits, as per your needs.
Pros and Cons of Permanent Life Insurance
Permanent life insurance offers lifetime protection and an opportunity to grow wealth. But like any other financial product, it has potential pitfalls. Being aware of them can help you make an informed decision regarding whether it is right for you or not.
1. Tax-deferred growth
Your policy’s cash value grows tax-deferred. This means you will not have to pay tax on any interest or capital gains, until you withdraw them.
2. Lifetime coverage
Permanent life insurance gives you the peace of mind that your dependents will eventually receive the death benefit. Your beneficiaries will receive the payout as long as you keep the policy valid, whether you die in four or 40 years.
3. Access to cash value
As a policyholder, you can access cash value at any time without incurring penalties, unlike in retirement plans like RRSP.
4. Accelerated benefits
Most permanent life plans (if not all) allow you to access a portion of the death benefit — typically up to 80% — if you are diagnosed with a critical illness.
5. Multiple uses
Unlike term life, permanent life insurance can be used for several things other than income replacement. You can use it for estate planning, business succession planning, diversifying your investment portfolio, and leaving behind an inheritance.
Cost is the biggest drawback of permanent life insurance. It is anywhere between five to 15 times more expensive than term life insurance, on average.
2. Tax implications
While you can tap into the cash value at any time, doing so could have tax implications.
3. A policy loan or partial withdrawal can reduce the death benefit
If you withdraw the cash value partially, the death benefit is generally reduced by the amount withdrawn. If you take a policy loan and die before repaying it, the insurer will reduce the death benefit by what is still owed.
How Permanent Life Insurance Builds Wealth
Apart from the death benefit, permanent life insurance allows you to accumulate cash value. You can use it for paying future premiums, borrowing money from the insurer at a low interest rate, and for supplementing the retirement income.
But how exactly does permanent life insurance accumulate wealth?
Your monthly premium payments are split into two categories:
- Covering the net cost of insurance from the insurance company
- The rest is invested into a savings account or investment portfolio
As you age, the cost of insuring your life increases for the insurance company. This is why purchasing a new life insurance policy becomes more expensive as you get older. When it comes to permanent life insurance, insurers take these increasing costs into account.
Initially, a larger portion of your premium is invested in the cash value account. This can lead to quick growth in the early years of the policy. But as you age, more of the premium goes towards the cost of insurance, slowing cash value accumulation.
Bear in mind how cash value is built up varies depending on the policy type. A whole life plan accumulates cash value at a fixed rate set each year by the insurer. In contrast, universal life plans accumulate cash value at a rate that is based on market conditions.
Both whole life and universal life policies accumulate cash value on a tax-deferred basis. This means interest gains or investment gains are not subject to taxation as long as they remain within the policy. As a result, the cash value grows faster because it is not being reduced by taxes Additionally, if you are in a lower income bracket when you withdraw the cash value, you will pay less tax than when you were first contributing to your account.
Thanks to these tax benefits, permanent life insurance can be a smart option for building wealth for certain individuals.
Whole life and universal life policies offer benefits beyond the death benefit. These policies accumulate cash value, which you can borrow or withdraw at any time while you are still alive. Consider such a policy if you are a high earner or have long-term financial obligations.
Want to buy a cash value life insurance policy but not sure where to start? Let Dundas Life help you. Our experts can offer you unbiased advice on where to start. We will also pull up quotes for you from top-ranking providers so that you can tailor a policy to your budget.
Frequently Asked Questions
Is the cash value of a life insurance policy taxable?
The cash value is not taxable while it remains within the policy. However, if you take out a policy loan or make a withdrawal, there could be tax implications.
With a cash withdrawal, the amount over the policy’s adjusted cost basis — the total premiums paid less the cost of the actual insurance — is taxable. Policy loans, by contrast, are not subject to taxation as long as the policy is active. But if you surrender the coverage without repaying the loan, the amount that exceeds the adjusted cost basis would be taxable.
Can life insurance help protect my assets from creditors?
Creditors cannot take the death benefit from your beneficiaries if you leave behind outstanding debts. Nor can they force you to surrender coverage for the cash value to repay them.
How does life insurance help in estate tax funding?
Life insurance pays a tax-free lump-sum benefit that can be used for paying the deceased person’s taxes, probate fees, and other legal costs (like the estate executor’s salary). By covering these costs, life insurance can help preserve the value of your estate, ensuring your heirs get the exact inheritance you wanted them to receive.
What is the role of life insurance in business succession planning?
A life insurance policy can be used for funding a buy-sell agreement, which provides the surviving business owner(s) with liquidity to buy out a deceased owner’s share. This in turn reduces business interruption and ensures smooth ownership transition.
Is life insurance a good strategy for high-net-worth individuals only?
Permanent life insurance can help high-net-worth individuals to diversify their investment portfolio, but that does not mean it is not an option for others. If you have dependents, you may want to consider life insurance, regardless of your income. Should you pass before your time, the life insurance payout can help your loved ones stay financially afloat and possibly even save for the future.