When Life Insurance Can Make Sense
“… a foolish man builds his house on the sand. And the rain fell, and the floods came, and the winds blew and beat against that house, and it fell, and great was the fall of it.” – Matthew 7:24-27
When building an investment portfolio, it is important to build on a solid foundation. For this reason, it is important to consider the implications of the death, disability or illness of the family breadwinner, property loss, theft or damage, and liability claims. That way, if a disaster does happen, the family doesn’t get wiped out in the process.
For this article, we’ll discuss the issue of life insurance. Personally I’m not a big fan of life insurance. I consider it an expense you shouldn’t pay for unless you clearly need the protection. I’d like to take you through what I consider are the exceptions to where life insurance can make sense.
- Protection of the life of the family breadwinner
For a family with young children and few financial resources, the death of the family breadwinner can leave the surviving spouse and kids without means to support themselves.
So, getting enough insurance cheaply is generally the goal. One source for cheap insurance may be your employment group insurance. If the cost per dollar of insurance is lower than that of buying private insurance, then you might top up your group coverage.
We’ll also check to see if your employer pays any part of the insurance cost as this “taints” the proceeds making them taxable. Here we’ll explore whether it’s better for you to pay the entire life insurance premium (and have your employer pay more of the cost of other benefits) so that the life insurance proceeds will be tax-free. We might also look at private term insurance to top-up your coverage if needed as the limits on group insurance may not be adequate enough for your needs.
Where you own a business
If you own a business, term insurance for which your business is the owner and beneficiary can make great sense. Although the life insurance premium is normally not deductible, you are paying the insurance premiums that have been subjected to just the company tax rate (The small business tax rate for British Columbia is 13.5% combined). As such, you might be able to buy up to 30% more insurance for the same money compared to buying the insurance personally from after-tax employment or dividend income.
The company owned life insurance death benefit is paid to your company on your death tax-free. The death benefit (less the tax cost which is ‘nil’) is credited to the Capital Dividend Account. This amount can then be paid out as a tax-free ‘capital dividend’ to your family.
Note that the company owned life insurance is an asset of your company and the death benefit can be subjected to your creditors. Should you be in a position where you are able to retain some company income, an investment holding company can make sense as a way to remove surplus funds from exposure to potential creditors.
- Insuring an annuity
Insurance on a life annuity to replace the capital on death can make sense. Let’s look at annuities and then see how insurance can work together with it.
- A) What is an annuity?
An annuity is a contract providing you with periodic cash receipts (usually paid monthly, quarterly or annually) in exchange for an up-front lump sum payment. There are two types of annuities:
– those that pay for only a specific period of time (term certain annuities), and
– those that pay as long as you live (life annuities).
A life annuity bought from personal monies (non-RRSP/RRIF or non-company money) qualifies as a Prescribed Annuity which is entitled to beneficial taxation as only part of the income is taxable.
Let’s say you’re a 65-year old man and you have $250,000 to invest. You want to invest this money to provide you with regular income to meet your living needs.
One possibility (see “Option 1” on Schedule 1) is to buy a corporate bond that earns 4.5%. At the 40% tax bracket, your after-tax return is 2.7%.
Another choice (see “Option 2” on Schedule 1) is to buy a Prescribed Annuity for $250,000. The annuity will pay you $19,996 each year no matter how long you live. And as a Prescribed Annuity, only $5,431 of each year’s receipts is subject to income tax (i.e. 72.8% of the total receipts is a tax-free return of capital). So at the 40% tax bracket, you’ll end up with $17,793 in your pocket each year. A bond would have to pay interest at a rate of 11.86% to give you the same amount of income after-tax.
There are two reasons why you receive this big boost in yield. First, you lose access to the capital – you’re only entitled to the monthly cash receipts. This makes sense because the insurance company must invest those monies for the long term to generate excess returns to pay you your guaranteed return.
Second, on death, the cash receipts terminate leaving no annuity capital for your loved ones.
- B) That’s where life insurance comes in
Where you want the annuity capital for your loved ones when you’ve passed away, you can do this through buying life insurance. With life insurance, the annuity capital will be paid as a death benefit to your loved ones when you’ve passed away. But to provide this return of annuity capital on death, part of the annuity cash receipts is used to pay life insurance premiums.
|Schedule 1: Comparing the Returns of Bonds to Annuities|
|Option 1||Option 2||Option 3||Option 4|
|Bonds||Prescribed Annuity||Insured Annuity||Charitable Insured Annuity|
|Less: up-front insurance premium||–||–||($656)||($656)|
|Net Amount of Bond/Annuity Purchase||$250,000||$250,000||$249,344||$249,344|
|Gross Annual Income||$11,250||$19,966||$19,913||$19,913|
|Income Tax (40%)||($4,500)||($2,172)||($2,167)||($2,167)|
|Add: Charitable Credit||–||–||–||$3,440|
|Less: Annual Insurance Premium||–||–||($7,872)||($7,872)|
|Net Annual Income Receipts||$6,750||$17,793||$9,875||$13,315|
|After-Tax Cash Yield||2.70%||7.12%||3.95%||5.33%|
Donation to Charity on Death
Note: The annuity is a life only annuity with 0 guaranteed years of payments based on a 65 year old male. The life insurance is a Term to 100 policy for a non-smoker male age 65 at a cost of $656 per month. This is an illustration only and does not constitute an offer to buy an annuity or life insurance.
This return of annuity capital is shown under the third alternative (see “Option 3” on Schedule 1). For a 65 year old non-smoking man, $250,000 of term-to-100 life insurance is purchased costing $656 per month. (Note that with insurance you pay the first premium up-front). That leaves $249,344 to buy the Prescribed Annuity. The annuity will pay $19,913 each year of which $5,416 is taxable income. When taxes of $2,167 and the full-year’s insurance premium of $7,872 are paid, you end up each year with $9,875 in your pocket. A bond would have to pay interest at a rate of 6.58% to give you the same amount of income after-tax.
One of the neat things about an Insured Annuity is that if your spouse dies before you, you can discontinue the term insurance. As a result, your net after-tax receipts increase from $9,875 to $17,747; that’s 7.1% after-tax. A bond would have to yield 11.83% to provide the same return.
If you need income and are charitably inclined, you can boost your income and also provide a nice endowment to your favorite charity. Under this option (see “Option 4” on Schedule 1) your insurance premiums payments become charitable donations (as the charity owns the insurance) for which you’ll be entitled to the charitable credit. Assuming you have more than $200 annually in other donations, the charitable credit on the $7,872 insurance premiums will be $3,440 (based on the highest tax bracket rate of 43.7%). Here you’ll end up with $13,315 after-tax in your pocket each year as long as you live – almost double the after-tax income of the corporate bond of Option 1. A bond would have to yield 8.88% to provide the same return. By your age 84, you’ve gotten your capital back and you’re still receiving $13,315 a year. On your death your favorite charity receives $250,000.
- Maximizing pension income
Let’s say you’re married and you participate in your employer’s defined benefit pension plan – this is a pension that provides a guaranteed amount of pension income based on your average salary and years of service.
At retirement, you’ll have to make a decision on the type of survivor benefit you wish to provide for your spouse on your death. The problem is that the cost of a survivor pension can be very hefty. We’ve seen these costs range as high as 20% to 35% of the unreduced (life only) pension.
Under a pension maximization strategy, you maximize your pension income by taking the life only pension only if you can buy a survivor pension at a cheaper cost elsewhere.
To see how this works, let’s assume that a life only pension (the unreduced and non-guaranteed pension) you’d receive would be $4,000 per month until you die at which time your spouse gets nothing.
You want to provide a pension to continue for your spouse after your death. Your company offers you a 100% Joint and Last Survivor Pension. Here this pension pays you $3,000 a month (instead of $4,000) as long as you live. And when you die, it pays $3,000 a month (= 100% of your $3,000 pension) as long as your spouse lives.
Under a pension maximization strategy, you elect to take the life only pension of $4,000 per month if you can provide a survivor pension of $3,000 per month at a cost of less than $1,000 per month.
Let’s say we can buy an insurance policy (like a Term to 100 policy) that provides for the same $3,000 a month survivor pension at a cost of $300 per month after tax (or $500 before tax at the 40% tax bracket). As a result, you’ll end up with $6,000 more a year in pension income. And if your spouse dies before you, you could cancel the insurance policy and end up with $12,000 more each year of pension income.
The reason why this strategy can work is that your employer is determining your pension options based on a life expectancy table for a group of people at your retirement age – it is not based on your particular health. So, if you’re healthy you might be able to lock-in a cost of insurance that’s cheaper than your future group rate.
- Business insurance
There are three common situations where one might buy life insurance related to a business:
A) Key man insurance
The purpose of taking out key man insurance is to compensate the employer for the loss of income resulting from the loss of the service of a key employee in the event of their death. For the life insurance component of the policy, it is normally term insurance over the employee’s expected employment. (The policy might also include coverage in the event of the key person’s sickness or injury.)
Life insurance might also be provided as a remuneration retention tool as part of a group benefits package for your employees. Although there are requirements as to the number of employees required for a group to be established and that all full-time employees may need to participate, it can represent a cost effective way of providing benefits by you that an employee might not otherwise be able to obtain on their own. For example, an employee might not be insurable and qualify for private insurance. Alternatively, private benefits – like extended healthcare, tend to be available to lower coverage limits or not be as comprehensive as group benefits.
B) Buy-Sell insurance
In the event of your death, a Buy-Sell Agreement funded with life insurance provides insurance proceeds to your business partner who is contractually obligated to buy out your interest in the business on your death at a guaranteed price by a guaranteed date.
Similarly, in the event of your business partner’s death, a Buy-Sell Agreement funded with life insurance (which some refer to as “Buy-Sell insurance”) provides you the proceeds to buy out your deceased partner’s business interest. The last thing you might want is to be in business with your deceased partner’s spouse or kids.
A Buy-Sell Agreement that’s fully funded with life insurance provides an opportunity to reduce the capital gains tax liability on the deemed disposition of your shares. For example, if your shares pass to your surviving spouse on your death and vest in their hands, you’d want your surviving spouse to have an option to redeem your shares at a pre-established fair value that’s fully funded by life insurance. The redemption can be structured as a return of capital (for which the company is required to declare a capital dividend equal to the fair market value) and no capital gains tax might result on your shares. If you have no spouse, there will be some amount of capital gains tax given the Stop Loss rules that limit the amount of dividend to a 50% capital dividend (with the balance a taxable dividend); however, the savings still makes good sense.
C) Maximizing your company value on your death
If you own private company shares, on the last to die of you and your spouse, these shares are deemed disposed at market value resulting in capital gains taxes. Taxes are payable a second time where company assets are disposed of (creating taxable capital gains) and distributed to shareholders (which might be in the form of dividends subject to tax). So, your company investments are subjected to tax twice – once at your death and then again when realized and distributed.
If your company has surplus assets, it may be possible to reduce these taxes where the company owns an insurance policy on the life of the shareholder. Here surplus company assets are used to pay insurance costs which reduces the pool of surplus assets. What this does is convert surplus assets to a death benefit that can be excluded in valuing the company for tax purposes. Most or all of this death benefit is credited to the Capital Dividend Account that can then be paid to your heirs tax-free.
The result is that through insurance you may be able to reduce capital gains taxes at death. And this reduction in taxes can be greater than a plan to simply redeem company shares at death.
The Next Step
If you think insurance can be of value to you or if you’d like us to review your existing insurance policies, please call me at (604) 288-2083 (x2) or email me at email@example.com.
Written by Steve Nyvik, BBA, MBA ,CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.