Unless the client wishes to leave an estate to his heirs upon his death, universal life insurance can prove to be a tax-disadvantageous product.
“If a client has an estate goal, the universal life policy is the best place to invest. If he doesn’t, that’s the worst idea,” sums up Dany Provost, tax specialist and president of Delta Services Actuariels.
The tax treatment of life insurance explains this finding. First, the main advantage of universal life insurance is that death benefits are non-taxable for the beneficiary of the policy. Thus, unless you die at a very advanced age, the after-tax amount bequeathed to the beneficiary heirs will be higher than if you save in a non-registered account, in a registered retirement savings plan (RRSP) or tax-free savings account (TFSA).
Universal life insurance is even more advantageous for a shareholder of a company. “When the insurance policy is company-owned, it’s much more efficient than a TFSA, because the premium is paid before personal taxes. When individuals are shareholders in a company, the policy is often transferred to the company to have the company pay the premium,” explains Dany Provost.
In this case, the company must also be the beneficiary of the insurance. Otherwise, the payment of bonuses by the company will be considered a taxable benefit in the hands of the shareholder, which is tax disadvantageous. “The company, being a beneficiary, there is no taxable benefit. The life insurance principal, less the adjusted cost base, will be paid into the corporation’s capital dividend account (CDA). The company could allocate a capital dividend to a shareholder on a discretionary basis and thus pay him a tax-free dividend that will go to the heirs,” notes Dany Provost.
However, when the client expects to receive the money saved through his universal life insurance during his lifetime, this product is significantly less advantageous than saving in an RRSP, TFSA, RESP, a non-registered account or even paying off his debts.
Indeed, universal life insurance is taxed in three ways. First, premiums are taxed at 2.55%. “If there is an insurance cost of $3,000 per year and the insured pays $10,000, the 2.55% will be charged on $10,000. The tax affects the investment portion,” says Dany Provost.
Then, the insurer will have to pay a federal tax of 15% on the investment income. “This tax will be considered in the management fees, for example. The investor will not see this tax. It is a tax which is hidden”, attests the tax specialist.
Finally, at the time of withdrawal, the customer will be taxed at their marginal rate on the difference between the amounts collected and the adjusted cost base. Generally, the older the policy, the lower the adjusted cost base and the closer the taxable amount will be to the amount obtained.
“For someone saving for retirement, it’s not the right vehicle, because the premium isn’t deductible like an RRSP. In addition, because of the cost of insurance, we penalize ourselves. There’s no logical reason to put money in a life insurance policy if you’re sure you want to use it when you retire,” maintains Dany Provost.
Universal life insurance is therefore aimed more at wealthy debt-free clients who have maximized their RRSP, TFSA and RESP contributions wishing to bequeath a large estate.
Extreme case
If a client still needed to fund their retirement and had no other option but to use their universal life insurance to do so, it is possible to obtain tax-free money through this insurance.
“The technique consists of giving our policy as collateral to a financial institution in order to obtain a loan. The financial institution will pay up to a certain percentage of the cash value of the policy. But it’s very risky and it’s not very popular,” warns Dany Provost.
The risk arises from the possibility of market fluctuations, which would abruptly reduce the value of the policy fund pledged. In the event that the amount borrowed exceeds the maximum limit set for the loan, the financial institution could recall part of the loan.
“The individual would then be obliged to repay his loan to a financial institution. But, he has a good chance of not having the cash. At that point, he will have to sell his policy to get the money. The problem is that he has a large tax bill at the time of the sale, because what is taxable in the policy is the cash surrender value less the adjusted cost base. And this amount is not a capital gain. It is 100% taxable. If the policy has a value of $300,000, that’s $300,000 taxable. It hurts a lot,” he said.
Hence the importance of implementing this strategy with caution, by borrowing less than the maximum allowed by the lending financial institution, points out Dany Provost.
An exception could, however, allow the client to receive the amounts tax-free during their lifetime. Certain policies offered, in particular by the Mouvement Desjardins, make it possible to obtain the sums accumulated if the insured is struck by a serious illness, a loss of autonomy, a disability or if he had to undergo surgery, says Claude Beaudoin, financial security advisor at Desjardins financial security.