Using Life Insurance to your (tax) advantage

It provides some benefits that may be attractive to people in the affluent income group.Excerpt from the Toronto StarEllen Roseman In last week's column, we talked about the way mortgage lenders push you to buy life insurance to cover your loan. The lender's insurance, while convenient, offers less protection than what you would get with a life insurance policy sold separately.Here are the main disadvantages of buying mortgage life insurance from a bank, trust company or credit union:The lender owns the policy and is the beneficiary. With a policy you own personally, you own the policy and choose the beneficiary.The lender's insurance is not portable. If you switch lenders, you may not be able to get insurance if you have a health problem. But if you own a guaranteed renewable policy, you will never have to provide medical evidence again.The lender's insurance doesn't decrease in cost, but the coverage shrinks as your mortgage balance declines. With a policy you own personally, the coverage doesn't go down unless you reduce it.Another problem (not mentioned last week) is post-claim underwriting. This means the insurance is sold to those who may be ineligible for benefits.Only when someone dies is an assessment done. And the claim may be denied if the death is related to a pre-diagnosed medical condition.When you own your life insurance policy, the coverage is underwritten at the time of application. It's almost impossible for the insurance company to get out of paying a death claim after the first couple of years.So, what kind of life insurance should you buy?Term insurance is the way to go when you're young. You can protect your spouse and children at a low cost because you're buying only insurance – with no savings or cash value.It's a no-frills way to insure your-self for a specific period of time. And if you survive to the end of the period, the policy is worthless.However, a term policy gets more expensive as you get older. You may find the cost prohibitive in your 70s or 80s, if you can get coverage at all."The probability of dying increases, so the insurance company must charge more to cover this risk," say financial professors Moshe Milevsky and Aron Gottesman in Insurance Logic: Risk Management Strategies for Canadians.But why will you need life insurance once your mortgage is paid off and your kids are grown up? What's the point of having it if you have no dependents?The answer is taxes. Life insurance provides some benefits that may be attractive to people in the higher income groups.With a permanent (or non-term) policy, part of the premium goes toward pure insurance coverage. Another portion goes toward a savings component to fund future premiums.This type of coverage also goes under the name of whole life, universal life or level life insurance. The premiums are higher than term premiums for the first part of your life, while term premiums exceed level premiums later on."Level, or permanent, insurance is a system whereby you overpay in the early years in order to subsidize the later years," the authors say."Since you're overpaying in the early years, the excess over the pure premiums is being invested in a side fund. In some cases, you can actually control where those excess premiums are invested."As you age, some of the savings will be depleted to make up for the fact that your annual level premiums are lower than what they should be."Some people buy life insurance for estate planning. While Canada has no death taxes, your estate will be taxed on the appreciated value of everything you own at the time of death – such as securities and real estate (aside from a principal residence).Faced with a large tax bill, your survivors may have to liquidate assets."In other words," say the authors, "the tax code can force you to sell the very asset that you are paying taxes to inherit. Ugh!"Besides helping to pay the final tax bill, life insurance can provide tax benefits along the way.The savings that build up inside a cash-value policy are sheltered from tax. You won't get a tax bill every year for interest, capital gains or dividends earned inside the policy, as you will when you invest in a bank deposit or mutual fund.Suppose you can defer tax for 30 years. How much would that saving be worth? The authors give an example.Imagine that you invest $10,000 at 5 per cent interest. If you pay tax each year on the gains at a 50 per cent marginal tax rate, you will have $20,975 at the end of 30 years.But if the inside build-up is tax-free, you have $43,220 at the end of 30 years – a gain of $33,220. Once you pay a 50 per cent tax on the gain – since you can't escape tax forever – you're left with $26,610."Compare the numbers," they write. "You have $5,635 ($26,610 minus $20,975) more from the tax-free inside build-up than from the alternative product."This is about 50 per cent of your initial $10,000 investment. Now scale this up to $100,000, or even $500,000, and you get a sense of the magnitude of this benefit."You have paid taxes in both cases, so we are not comparing apples to oranges. In the first case, you paid tax continuously; in the second case, you paid it at the end."You can use this strategy with a large variety of investment funds within a life insurance policy. That's why it's called universal life.Sometimes, financial advisers urge clients to buy life insurance policies for their newborn children.Why buy life insurance for children who have no dependents to protect?Adult children may not contribute to a registered retirement savings plan until they're 30 years old, says Asher Tward, vice-president of estate planning at TriDelta Financial Partners in Toronto.But they can have investments growing tax-free from birth if their parents buy them a universal life insurance policy. The policy costs very little at an early age, he says. You'll be doing your kids a favour since they will never have to buy life insurance again – and they won't have to worry about being uninsurable if they develop a medical problem later in their lives