November 4, 2007

The Overlooked Advantages of Universal Life

Universal Life (UL) insurance has three key advantages
  1. Tax-deferred growth, potentially permanently
  2. Tax-free retirement income through leveraging
  3. Tax-free death benefit
Unfortunately, most Canadians are unaware or skeptical. There's a widespread belief that it’s better to buy-term-and-invest-the-difference. So affluent Canadians take advantage of UL with the endorsement of their accountants.

Buy Term and Invest The Difference
This seems like a great idea. Term insurance is cheaper than permanent insurance. So there’s more money to invest outside. Yet astute investors like Warren Buffett buy permanent insurance, especially UL.

Why is term insurance cheaper? Because it’s worth less. Coverage expires before most people do. So term insurance is well-suited for folks with young families and debts like mortgages. Term insurance is used for estate creation by people with little money. They buy term but don’t have money to “invest the difference”. They probably have unused contribution room in their RRSPs.

Life insurance was created to be an instant estate in the event of the premature death of the breadwinner. --- Herb Perone
In contrast, permanent insurance is used for estate preservation and tax planning by people with money.

The Math of Compounding
“The most powerful force in the universe is compound interest.” --- Albert Einstein
Tax cripples investment growth. Conventional investments earn
  • interest (taxed at 46.41% in Ontario)
  • dividends (taxed at 24.64% or 31.34%) or
  • capital gains (taxed at 23.20%)
(For other provinces, see 2007 Tax Facts and Figures from PriceWaterhouseCoopers).
As with an RRSP, the tax rate on growth inside UL is 0% until withdrawals are made (then taxed your marginal tax rate). Tax deferred is tax saved --- a huge benefit.

Here’s a simple example that shows the consequences of tax: What does $1 growing at 100% per year become after 20 years? $1,048,576. Suppose growth is taxed at 35%. The after-tax accumulation shrinks to a minuscule $22,371. With sheltering, tax is applied to the ending accumulated value, giving $681,574. For the math, see the table in $1,000,000 After Taxes on Investment Growth. For another example, read Do You Understand Compound Interest?, which has a live calculator

Tax-deferred Growth
You saw the power of tax-deferred growth above.

UL lets you make deposits well above the RRSP contribution limits (the maximum is limited by the death benefit, which you select). Because withdrawals are not mandated, the savings can be paid out as part of the tax-free death benefit.

Tax-deferred growth has another advantage. Insurance charges are partially paid by investment growth that was never taxed --- the government helps pay your premiums. This can't happen with term insurance because there's no tax-favoured savings element

Tax-free Retirement Income
If you need retirement income, you have the option of getting tax-free income by using the savings as collateral for a bank loan. You can skip the loan payments and have the loan repaid with the tax-free death benefit.

If you’re accumulating large sums, do you want to risk losing it to creditors? When properly-structured, life insurance can be creditor-protected.

The advantages of universal life insurance lead to many creative strategies.

1 comment:

Brian Poncelet,CFP said...

Hi Riscario,

I'd like your thoughts on participating whole life insurance using paid up additions. Assuming one is buying the least amount of insurance and the most amount allowed of cash (CRA rules) vs. Ul.

Great site! My talk with an actuary recently was the investment side of things the internal fees is about .20 for the bonds, stocks etc. they handle, does this sound right? The dividend split between insurance and investments is a bit of a secret, but let me know your overall thoughts.