Using Life Insurance To Shelter Income

In a nutshell, a tax shelter allows your investments to grow free of tax. Many people think tax shelters are only for the rich but the biggest users of tax shelter is the middle class. When you buy a RRSP (IRA or 401K in the US), you are in fact buying a tax shelter. The money made inside the RRSP is allow to grow tax free until it’s taken out.

There are a few problems with a RRSP. The first is the Canadian government won’t allow you to put more than 18% of your income or $16,500, whichever is less, into a RRSP. The second problem is the money is subject to income tax when it’s taken out.

Another way to shelter income is by using life insurance. Life insurance proceeds are passed tax free to your beneficiaries. That’s good for your beneficiaries but what if you want the money? All whole life and universal life insurance policies have a cash surrender value that you get if you give up the insurance. If you take the cash, your beneficiaries get nothing and the money taken out gets taxed. Not a good deal. However, there is a way around this.

With the exception of term insurance, all other life insurance policies are made up of two components, the insurance component and an investment component. The key here is the investment component. While the money is inside the policy, its allowed to grow tax free, just like a RRSP. Knowing this, many investors put way more money than they have to into their policy. For example, a 37 year old non smoking female has to pay $622.50 a year to get $1 million of life insurance. If all she does is put $622.50 into her plan, all she’ll have is insurance. Anything above that amount goes into the investment component.

To prevent people from dumping in their life savings, the government sets limits on the maximum premium you can pay into a policy and still keep its tax shelter status. In the above example, the maximum is $41,847.61 a year. The higher your insurance needs, the higher the limit. Let’s assume that the above put $41,000 a year into her policy for 3 years and then stops after that. After paying for insurance cost the rest will go into the investment component, where it will grow tax free. If we assume an 8% yearly rate of return the policy will have a cash value of $1.3 million and death benefit of $2.15 million when our 37 year old female reaches 65. If she takes the cash, it gets taxed and she loses the death benefit. How can she take cash out, keep the death benefit and not pay taxes? By borrowing against the cash value.

A bank will lend up to 90% of the cash value on an insurance policy. So our investor can borrow up to $1.17 million from the bank to spend as she feels like. The money would not be taxed because it’s not income. The bank would capitalize the loan so she doesn’t have to make any payments. How does the bank get its money back? When she dies, the death benefit will pay off the bank loan plus accrue interest and any money left over will go to her beneficiary tax free.

So here you have an investment strategy that is completely sheltered from tax, allows you to take money out of the plan tax free, and allows you to transfer your estate to your heirs’ tax free. As with all investments, you should seek out the advice of an experience financial planner before proceeding.


17 thoughts on “Using Life Insurance To Shelter Income”

  1. Lemmy says:

    Great Article John! Now all you have to do is wait till your 65 so you can finally get that Vette! 🙂

  2. Stephen says:

    Good strategy that’s been in place for me for a little while.

  3. Wes Novack says:

    Nice article! I’ll have to look into US tax laws to make sure it applies here as well!

  4. John Chow says:

    We don’t have such a test here. As long as you don’t exceed the maximum allowed premium, your policy will maintain its tax shelter status.

  5. Lawrence says:

    “Here” meaning Canada only?

    In America that life insurance coverage is no bonus — it is a problem. A very expensive problem.

    Cash-value life insurance, including VUL, does have certain tax advantages. The issue is whether those advantages are worth the high costs of the insurance part. The answer is almost always no — especially because you can get tax treatment that works just as well at little or no cost.

    The cost of VUL, apart from the fees hiding behind every aspect of the policy, is the cost of insurance. It is far from free: every month, you are charged an insurance charge for the insurance (other than the part that’s covered by your cash value). If you want that insurance, you can almost certainly find someone else who’s selling it cheaper. Lots of people have absolutely no need for it, and shouldn’t be buying it.

    Once upon a time, you could avoid that problem by just having the insurance component of the policy be really small. Nowadays, though, Congress has cracked down on that: your life insurance coverage, which you’re paying for, can’t be small compared to the cash value. There are a few ways of satisfying the tax rules, but under the most common, for everyone under 40, the death benefit is required to be at least 250% of the cash value. So, if you put in, say, $100,000 to start funding your retirement, you MUST have a death benefit of at least $250,000, so you’re paying every month for at least $150,000 of life insurance, whether you want it or not.

  6. Lawrence says:

    Hey, why was my post removed? I wasn’t trying to argue… I just was trying to mak eit clear that this will not work in the USA.

  7. 1awrence says:

    Hey, why was my post removed? I wasn’t trying to argue… I just was trying to make it clear that this will not work in the USA.

  8. John Chow says:

    I didn’t remove any post. And I do recall your post about it. I don’t know what happen. Could the Spam Kara 2 software deleted it. Feel free to post it again.

  9. John Chow says:

    OK, I have recovered the posts. The Spam Kara 2 software killed it. I am running a new spam filter now. Hopefully this one performs better.

  10. Brandon says:

    Actually Lawrence, this is a good solution in the U.S.A. even with the cost of the “Pure” insurance added in the policy. If you run a Net to Net (Monte Carlo), 98% of the time the the life insurance will still function to the benifit of the policy holder.
    Thats not to mention that the life insurance can pay for estate taxes to your heirs, it transfers to the beneficiary tax free, and avoids probate. So unless your dying wish is to give uncle sam, your CPA, and your lawer a signifigant chunk of your money, most people do infact have a need for life insurance.

  11. LuLu says:

    The name of this Insurance package is called (IRP) Insurable Retirement Plan. Most of the Insurance company have this plan. (ie: IA, RBC Ins…etc) Each insurance company have different types of Funds for you to invest but myself have IA since it have varies of Funds to choose instead of S&P Index as in RBC. For those who’s interested on this product, please let me know cause I can point you to a Free Seminar on this type of wealth management knowledge.

    Cheers;
    Lulu

  12. Yara Jbeili says:

    This is a great article indeed. I am a life insurance agent myself. I work at industrial alliance in Montreal, Quebec. Universal life insurance is mostly what i advise people to take. Like John stated, for people who want to insure the financial security of their families, and invest their money at the same time, free of tax, life insurance is the ideal product. All my clients are very satisfied so far. If anyone needs any information or help on getting to know the product more, please don`t hesistate to email me at [email protected]. I will be more than glad to assist you..remember it is always better to start at an earlier age, that is where the premium will be at its lowest. John you did explain it extremely well in a nut shell 🙂

    Yara Jbeili

  13. C Fox says:

    A huge, I mean HUGE, thing to watch is UL often have a mer of 2.0 (or higher) in the investment portion. With an average between 8.00 and 10.0% annual stock market return, this can cost half your gains over a 30 year period. You are not taxed on those gain, but if your gains are half…. you still lose.

  14. LuLu says:

    Compare to Mutual Funds, it is around 1.5-2.0% higher. But don’t forget you will have to pay 75% on Dividend or 50% captial gain in tax. If you are looking in an average of 8-10% annual growth for both then you are getting the same result but by using the UL one can save up the tax portion
    It is the one investment in Canada which you don’t have to pay tax. Don’t forget the money you invested in Mutual Funds, Stocks or RRSP are all after tax money, why do you have to pay double tax when you want to take it out.

  15. ct says:

    My question is how the insurance company makes money. For the example you gave, the lady paid $622/year for a $1,000,000 policy starting at age 37. If she die in 40 years, she will get a payout of 1 million dollars. In the 40 years, she only paid $24880 premium. The math does not seem to add up. How come?

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