Estate Planning: Life Insurance

When it comes to life insurance, there are many choices: Whole life. Variable universal life. Term. What do these descriptions really mean?

All life insurance policies have two things in common: They guarantee that they will pay a death benefit to a designated beneficiary after a policyholder dies (although the guarantee may be waived if the death is a suicide occurring within two years of the policy purchase). All require recurring payments (premiums) to keep the policy in force. Beyond those basics, the differences begin.

Some life insurance coverage is permanent; some not. Permanent life insurance is designed to cover you for your entire life, not just a portion, or "term," of it, and it can become an important element in your retirement planning. Whole life insurance is its most common form.

Whole life policies accumulate cash value. How does that happen?

An insurer directs some of your premium payments into a reserve account and puts those dollars into investments, typically more conservative ones. The return on the investments influences the growth of the cash value, which builds up according to a formula the insurer sets.

A whole life policy's cash value grows with taxes deferred.

After a while, you gain the ability to borrow against that cash value. You can even cancel the policy and receive a surrender value. Premiums on whole life policies, though, are usually higher than premiums on term life policies, and they may rise with time. Beneficiaries can only receive a death benefit and not the policy's cash value when a whole life policyholder dies. Some whole life policies will have an option that cash values to buy additional insurance which will increase amount of life insurance overtime to keep up with inflation. 

Universal life insurance is whole life insurance with a key difference.

Universal life policies also build cash value with taxes deferred, but there is the chance to eventually pay the monthly premiums out of the policy's investment portion.

Month by month, some of your premium on a universal life policy gets credited to the cash reserve of the policy. Sooner or later, you may elect to pay premiums out of the cash reserve, so the policy essentially begins to pay for itself. If all goes well, a universal life policy may have a lower net cost than a whole life policy. However, if the investments the insurer chooses severely underperform, that can create an issue with the payment of the policy. If the cash reserves dwindle enough, the policy could end up being accidentally canceled if the premiums aren't paid.

Term life insurance is life insurance that you "rent" rather than own.

It provides coverage for a set period, usually 10 to 30 years. Should you die within that period, your beneficiary will get a death benefit. Typically, the premium payments and death benefit on a term policy are fixed from the start, and the premiums are much lower than those of permanent life policies. When the term of coverage ends, you may be offered the option to renew the coverage for another term or to convert the policy to a form of permanent life insurance.

Term life is cheap, but the trade-off comes when the term is up. Just as you cannot build up home equity by renting, you cannot build up cash value by renting life insurance. When the term of coverage is over, you usually walk away with nothing for the premiums you have paid.

Do you need a life insurance policy in retirement?

One school of thought says no. The kids are grown, and the need to financially insulate the household against the loss of a breadwinner has passed. If you are thinking about dropping your coverage for either or both of those reasons, you may also want to consider the excellent reasons to retain, obtain, or convert a life insurance policy after you retire. Take these factors into account and consult with your financial professional before making a decision.

Could you make use of your policy's cash value?

If you have a whole life policy, you might want to utilize that cash in response to certain retirement needs. If you need additional income, many insurers will let you surrender a whole life policy you have held for some years and arrange an income contract with the cash value. You can access the money, tax free, as long as the amount that is withdrawn is less than the amount paid into the policy. Remember that withdrawing money or taking a loan against a policy's cash value naturally reduces the policy's death benefit.

If you surrender your whole Life Insurance policy for its cash value, you will be taxed on some portion of the cash value that exceeds the adjusted cost base of the policy (ACB). There are other alternatives to access the cash value without tax. Please consult your Insurance/Financial adviser for more details. 

Will your estate be taxed?

The life insurance death benefit is generally tax-free in Canada. This is because most inheritances in Canada aren't taxable. There is no death tax or estate inheritance tax that beneficiaries need to pay out. The death benefit is paid directly to beneficiaries in one tax-free lump sum. 

Any income earned from the investment of death benefits will be taxable to beneficiary. If your estate upon your death result into taxable situation, your beneficiary have received tax free death benefit to pay your estate taxes rather then liquidating part of your estate or pay out of his/her savings or sell some estate assets to pay taxes or borrow against the estate assets to pay taxes.

Are you carrying a mortgage? 

If you borrowed to purchase your home or have refinanced and are carrying a mortgage, a life insurance policy may make sense. It could potentially relieve your heirs from shouldering some of or all that debt if you die with the mortgage still outstanding.

Do you have burial insurance?

The death benefit of your life insurance policy could partly or fully pay for the costs linked to your funeral or memorial service. In fact, some people buy small life insurance policies later in life to prepare for this expense. Alternatively, you may seek to renew or upgrade your existing term coverage for permanent life insurance.

Which coverage is right for you?

Many factors may come into play when you are deciding which type of life insurance will suit your needs. The best thing to do is to speak with a qualified insurance professional who can help you examine these factors so you can determine which type of coverage you should have.