Comparing life insurance and RRSPs at first may seem like comparing apples and oranges, because they are fundamentally different financial products. One pays your family a tax-free benefit upon your death, while the other lets you save for retirement on a tax-deferred basis.
However, permanent life insurance plans include a savings element that grows wealth the same way an RRSP does.
Which is a better investment tool — life insurance or RRSPs? Let’s find out.
What is an RRSP and how does it work?
A registered retirement savings plan (RRSP) is a tax-advantaged account in which Canadians can save for their retirement. Contributions up to the annual limitations are tax-deductible, allowing you to lower your taxable income. RRSP funds grow tax-free until withdrawn.
Even though it has the word “savings” in its name, an RRSP is more than a savings account. Alongside cash, it can hold several income-generating investments, including, but not limited to, stocks, bonds, and mutual funds.
You are eligible for an RRSP if you:
- Are a resident of Canada
- Have a valid SIN
- Have earned income
- Have filled income tax
You can set up an RRSP at any age, but minors need a letter of consent from their parents or legal guardians. RRSP contributions are tax-deductible up to the annual limit, which increases from time to time. Also, capital gains earned on income in an RRSP account are not subject to tax until withdrawn.
You can hold on to your RRSP account till age 71. By December 31 of the year in which you turn 71, you are required to close the account and withdraw the funds. Of course, you can make withdrawals before that if you want to, but remember that early RRSP withdrawals are subject to tax penalties.
Now that we have discussed what RRSP is, let’s look at how it works.
1. Set up an RRSP account
Setting up an RRSP is simple. Just select the financial institution you would like to open an account with, fill out the necessary application, and submit the required documents. You can open an RRSP account with a bank, insurance company, trust, or a credit union.
2. Start making contributions
RRSP contributions are subject to annual limits. Each year you can contribute the lower of:
- 18 percent of the previous year’s income
- the annual RRSP limit for that year (e.g. the annual limit for 2023 is $31,500)
Here’s an example. Let’s assume you made $50,000 in 2022. This means in 2023 you can contribute $9,000 into your RRSP (18% of 50,000 is $9,000, which is less than the annual limit for 2023).
Keep in mind that any unused contribution space gets carried forward to the future years. For example, let’s say you contributed $4,000 less than the annual limit in 2022. This means you can contribute up to $13,000 in 2023 ($9,000 + $4,000).
3. Make RRSP withdrawals at maturity
You can only hold on to an RRSP until 71. By the last day of the year in which you turn 71, you must withdraw the funds. Your withdrawal options at maturity are:
- Make a lump sum withdrawal
- Convert your RRSP to RRIF
- Buy an annuity
What is whole life insurance?
Whole life insurance is a type of permanent life insurance. It combines lifelong insurance protection with a savings component. Your whole life policy lasts as long as you do, provided you pay the premiums. Alongside the death benefit, it accumulates cash value at a fixed rate set each year by the insurer.
The cash value grows tax-deferred, which means that all investment earnings, including interest and dividends, accumulate tax-free until withdrawn. Because your money is not decreased by taxes each year, it increases faster as a result of this arrangement. Furthermore, tax-deferred growth allows you to shelter your income from taxes. If you withdraw the cash value of the policy when you are in a lower tax bracket, such as after retirement, it will be taxed at a lower rate than when it was initially placed in your account.
Many people use the cash value to supplement their retirement income, though there’s no rule that prevents you from accessing it earlier if you want to. Once the cash value reaches a certain amount, you can withdraw from or borrow against it at any time. You can also withdraw the entire cash value at once by surrendering the policy. But in that case, your policy will terminate and your beneficiary will not receive a payout upon your death. If you have people depending on your income, taking a policy loan or making a partial withdrawal is a better option than surrendering.
Whole life insurance is more expensive than term life insurance, which lasts for a limited period and does not accumulate cash value. Despite the high price tag, whole life insurance can be a good option for someone who:
- Wants to use the cash value as a supplement to a qualified retirement plan, like the RRSP
- Needs lifelong insurance protection
- Wants to use life insurance for estate planning
Life insurance vs. RRSPs
Similarities between life insurance and RRSP
Even though life insurance and RRSP are two distinct financial products, they share one key similarity. The savings component of life insurance accumulates wealth the same way as the RRSP does. With both, you can leverage the power of tax-deferral growth.
With a tax-deferred plan, you can delay paying income taxes until a future date. This in turn helps you grow your savings faster because investment earnings are reinvested. When you do withdraw the funds, you may be in a lower tax bracket than the one you are in today, which will result in an additional saving on top of the accelerated growth.
Differences between life insurance and RRSPs
Life insurance and RRSPs are more different than similar. The chart below highlights the key differences between them.
The bottom line
Life insurance and RRSPs each serve a different purpose. It may also make sense to invest in both, depending on your income and savings goals.
Frequently Asked Questions
What are the benefits of RRSPs?
RRSPs offer many advantages, some of the most important ones are:
1. RRSP contributions reduce taxable income
With an RRSP, your contributions are tax-deductible. You can deduct the amount you put into your RRSP each year from that year’s taxable income when you file the taxes. This could potentially lower your tax liability and lead to greater savings.
2. Investment earnings grow tax-free until withdrawn
All earnings on assets, including interest, investment gains, and dividends, are tax-free as long as they remain in the account. This arrangement permits your funds to increase more quickly.
3. A spousal RRSP can lower the combined tax liability
Do you earn significantly more than your spouse? If so, contributing to a spousal RRSP can help you split the household income more evenly between the two of you and reduce the combined tax liability.
4. Multiple investment options
You can put many different kinds of investment products in your RRSP basket, including, but not limited to the following:
- Mutual funds
- Guaranteed investment certificates (GICs)
- Exchange-targeted funds (ETFs)
5. Unused contribution space gets carry forward
If, for some reason, you are unable to utilize all of the contribution space in a year, you have the option of using it later.
6. You can withdraw funds early without penalty in some situations
There are two situations in which a premature RRSP withdrawal is not subject to tax penalties. One, when you are purchasing your first home and two, when you use it to cover education costs for you or your spouse.
What are the benefits of whole life insurance?
Here are the five main advantages of buying whole life insurance:
1. Lifelong protection
Unlike term life insurance, whole life policies do not come with an expiry date. This means you can rest easy in the knowledge that your dependents will receive financial assistance upon your death, regardless of when that happens.
2. Builds wealth
Whole life insurance combines lifetime coverage with cash value, which accrues interests at a fixed rate and grows tax-deferred. You can tap into your policy’s cash value at any time while still living by taking a policy loan against or directly withdrawing it, partially or fully. Many people use their cash value to supplement their retirement income, but it can also come in handy when you have a big expense coming up or need some fast cash.
3. Tax Advantages
Typically, the life insurance death benefit is not taxable. Additionally, the cash value grows on a tax-deferred basis, meaning investment earnings are not subject to immediate taxation. Rather, they are only taxed on withdrawal. As a result, your money grows at a faster rate than normal rate. Tax-deferred growth can also lead to tax savings down the line if you withdraw the cash value when your tax bracket is lower than what it is today.
4. Potential Dividends
Some whole life insurance plans pay dividends, which can be used for buying more coverage, paying future premiums, or growing cash value more quickly.
5. Estate planning
Because whole life insurance has no end date, it can be a key estate planning tool. It can help you preserve the value of your estate for your heirs or distribute it equitably among your heirs.
Who benefits most from tax-deferred growth?
Tax-deferred growth is beneficial for all those who have a taxable income, provided they give their investments enough time to grow. However, the higher your tax bracket, the more you will benefit from it.
Let’s say you earn $300,000 annually and deposit $20,000 in your RRSP account. Because you are a high-earner, your top marginal tax rate is also high — 50%. The $20,000 RRSP contribution reduces your taxable income to $280,000 and tax bill by $10,000 (50% of 20,000).
Your friend, Miles, on the other hand, earns just $50,000 a year and has a top marginal tax rate of 10%. If he were to put $20,000 in an RRSP account, the total tax relief will be just $2,000.
When should I get an RRSP?
The earlier you start depositing money into an RRSP, the longer your investments will have the opportunity to compound. You can get an RRSP at any age, provided you have earned income and meet other requirements.