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By Ted Rechtshaffen and Asher Tward
There is nothing like finding cash where you don’t expect it and for some Canadians, their life insurance policy may just be that source of cash.
Many Canadians own life insurance, the most common of which is term life insurance. This is insurance you own for certain periods of your life, and then the coverage ends. It is often a 10- or 20-year term policy, indicating the number of years of coverage. Another common example is having term coverage that ends at age 65 or 75.
Unfortunately, there is no way to borrow against term life insurance in Canada, but it is possible using permanent life insurance with cash values, usually whole life and universal life, which is meant to cover some things beyond just risk management.
In short, it’s insurance that is meant to be held until death. It can be helpful for tax, estate planning, and simply as an investment asset class.
A large benefit of life insurance is the ability to use the cash value and even borrow against it. This would be similar in many cases to a line of credit, but rather than using your home as the collateral, you are using the cash surrender value of the life insurance.
This line of credit can be set up, and be used or not used, as needed. The best part is it provides access to capital that is not tied to your home and is otherwise not usable by you. This loan would only be repayable upon death using tax-free proceeds from the life insurance policy.
One area where we often use this type of insurance is in corporate planning. Some Canadians have professional or holding corporations that are helpful for tax purposes, but in most cases, you must pay tax on the assets if you ever want to use them personally (by withdrawing funds as taxable income or dividends).
Permanent life insurance is one of the best ways to get money out of a corporation tax efficiently. The biggest problem is that this is in most cases a generational transfer of funds, rather than assets you can pull out to use during your lifetime.
To overcome this issue, there is a specific way to set up a personal line of credit against the collateral in a corporate-owned life insurance policy. We see this as a unique opportunity: effectively making the living benefit of corporate cash available personally, while still having the tax-effective growth within the policy inside your corporation.
This is not just an opportunity for corporate-owned policies. If you hold a policy personally, and it has cash surrender value, you can also borrow against it.
Typical users of this corporate strategy would be a business owner or highly paid professional with an investment or holding corporation that has a value of at least $1 million and is generally not drawing money out of their corporation (or they are seeing the corporate assets growing faster than any withdrawals).
In these cases, owning life insurance in the corporation can be a great tax and estate strategy on its own, but the collateral line of credit might allow them to buy a cottage or other real estate investments personally, or use funds to help family members. If used to generate income, the interest cost would likely be tax deductible personally.
There are a few important things to remember.
With a collateral loan, you can borrow as much as 95 per cent against the cash surrender value of a whole life or universal life policy (sometimes less for universal life). If you have life insurance, but little or no cash surrender value, then there is nothing to be borrowed against.
The insurance policy must make sense as part of your overall planning. Borrowing against the policy can have real benefits, but the insurance planning comes first.
You will need a bank that has a specialized lending program to set this up.
Banks will re-look at the loan limits over time as your cash values rise. This is very valuable as most whole life plans dramatically grow over time, and this could create ever more funds that can possibly be borrowed.
Just like a line of credit that you might be more accustomed to, there is an interest cost, often in the range of prime plus 0.5 per cent for a collateral loan.
What I have been talking about here is collateral loans. There is a different way to borrow against a life insurance policy, and that is using what is called a policy loan, which is one where an insurance company will let you borrow against the policy itself.
One of the benefits of a policy loan is that you can capitalize the interest, meaning you can let the loan build without paying it down. This is structured so that the loan would be repayable at death, out of the Insurance policy proceeds. It is also an unconditional loan that requires no financial underwriting.
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A policy loan may seem fairly similar to a collateral loan, but there can be a big tax difference. It can get a bit technical, but if someone receives a policy loan from the insurance company, and the value of that loan exceeds the adjusted cost basis of their interest in the policy, then the loan will be considered as taxable income.
It is for this reason that we prefer collateral loans since the loan will not be considered taxable because it isn’t borrowed from the policy itself. That said, depending on your situation, there may be other technical considerations that should be reviewed with your accountant before proceeding.
Borrowing against a permanent life insurance policy isn’t an option for many, but for those who can do so, it can free up meaningful cash while you continue to have a tax-efficient and strong estate planning component in place.
Ted Rechtshaffen, MBA, CFP, CIM, is president and wealth adviser and Asher Tward is vice-president, estate planning, at TriDelta Financial, a boutique wealth management firm focusing on investment counselling and high-net-worth financial planning. You can contact them directly at [email protected] or [email protected].
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