Using Insurance Products as Investments in Canada - dummies

Using Insurance Products as Investments in Canada

Many Canadians think of insurance as a risk management tool, perhaps to cover off debts or to replace income in the case of a premature death. However, as unusual as it might seem, insurance can be used to help you manage your tax bill, both during your lifetime and in your estate. Read on to find out how!

Credit: “Canada Life on University Ave and Queen Street in Toronto,” © 2012 George Socka, used under a Creative Commons Attribution 2.0 Generic license: 

Investing inside a life insurance policy

If you purchase a “permanent” life insurance policy, such as a universal life policy, you can combine your insurance coverage with investments. From a tax standpoint, the insurance investments work very much like an RRSP (Registered Retirement Savings Plan) in that the investments grow tax-free and you won’t face a tax bill until the funds are withdrawn or the policy is surrendered (you don’t get a tax deduction for amounts put into the fund, though). Most universal life policies have a decent selection of investments to choose from, which means that the investment component of the policy has the potential to grow at a respectable rate of return.

Unlimited, tax-sheltered growth sounds too good to be true — and it is. Canadian tax law places a ceiling on the amount that can be in the investment account, and you will have to pay tax on some of the investment earnings if you make excessive deposits into your policy. Your insurance company will work with you to ensure you stay onside.

Life insurance proceeds (including any investments held within the policy) received on the death of the insured are received tax-free.

If you have investments that are likely surplus to your future needs, it might make sense to take out a life insurance policy to help tax-shelter the income that you don’t need. Over time, the tax features of the policy could mean that you have a larger pool of assets to leave in your estate. If you are the shareholder of a corporation such as a holding company or professional corporation, you can benefit from these tax rules (and more) by holding such a policy inside your corporation.

Only certain types of insurance policies offer investment values, including universal life and whole life (or participating) policies. When considering insurance as an investment ensure your ultimate goals and the type of policy you are looking at are compatible. Term policies such as a “term 10” or “term 20” are good for temporary risk management needs such as debt coverage or income replacement, while permanent policies can offer coverage for your entire lifetime as well as tax management features. If you want a policy to cover tax liabilities in your estate or to provide tax-sheltered investment values, a permanent policy is what you need.

Creating tax-efficient income with annuities

If you’re retired, or are approaching retirement, you may be concerned about generating stable income from your non-registered investments. Many decide they want to play it safe and choose fixed-income products like GICs (Guaranteed Investment Certificate). One problem with a full fixed-income portfolio is that the interest income is highly taxed at your marginal rate, which could be up to 50 percent of the income earned!

Enter annuities. Annuities are investment contracts you establish with a life insurance company. In return for an initial deposit, the contract will provide you with level and guaranteed payments for a certain time period, or for life. Part of the payment to you is taxable, but not all of it, which is why an annuity enhances your after-tax cash flow.

It’s possible to purchase an annuity with registered funds. In that case, the entire annuity payment to you is taxable, just like any other payment out of the RRSP or RRIF (Registered Retirement Income Fund).

The taxation of the annuity depends on the type of annuity you hold. In a non-registered account, you can have a prescribed or non-prescribed annuity. In either case, part of the payment to you is taxable as interest income, and part is considered a tax-free payment of your initial capital.

With a prescribed annuity you’ll have a level taxable portion each year, which is great for planning for your tax bill. It can also allow for some deferral of taxes because the taxable portion in the earlier years is less than it would be under a non-prescribed annuity. With a non-prescribed annuity, you’ll have more taxable interest income in the early years, and very little in later years. Your insurance company will help determine the right taxable versus non-taxable portion and report it to you each year.

Report the interest income earned from an annuity at line 121, unless you’re 65 years of age or older and receiving retirement income, in which case you report the interest at line 115, “Other pensions or superannuation.”

An annuity purchase is not reversible. You’re giving up your capital in return for the guaranteed income payments. Ensure you’re fully aware of the features of the annuity before you sign on the dotted line.

If you want to preserve your capital for your estate, you can purchase a permanent life insurance policy along with the annuity. This is commonly called an “insured annuity.” With an insured annuity, you can be comfortable that your estate will be replenished for the amount of funds you used to purchase the annuity. However, you do have to qualify for the insurance so make sure you apply for the insurance first, before committing to the annuity.

Knowing when segregated funds make sense

Segregated funds are similar in many respects to mutual funds, where your investment dollars are pooled with those of other investors and managed by a fund manager. Segregated funds are offered by insurance companies, and therefore have added insurance benefits not offered by traditional mutual funds.

The actual benefits you receive depend on the terms of your insurance contract. At a minimum, the contract will offer you a guarantee of at least 75 percent of your initial investment deposit at fund maturity or the death of the policy holder. Some guarantee up to 100 percent. In addition, some segregated funds allow you to lock in investment increases and base the future guarantee on this reset value.

Segregated funds offer some non-tax benefits including creditor-proofing in certain situations. This is often important for business owners or professionals who are afraid of being sued, and want to protect their savings in the case of a lawsuit. Another benefit is the ability to pass the assets outside of probate, which can save on probate fees on death in provinces where these fees are high.

From a tax standpoint segregated funds allocate income to investors each year, so you can expect to pay tax on dividends, capital gains, and interest. Segregated funds can also allocate out capital losses (mutual funds cannot), so investors will benefit from any losses realized by the seg fund if the investor has capital gains to offset. The income is allocated on a time-weighted basis, so if you held the seg fund for only a portion of the year your income allocations will be prorated. Again, this is not available with a mutual fund.

Any top-ups offered by the contract in the form of resets or guarantees are not taxable at the time they are given to the investor. Instead, they may be taxable only when the fund is sold, or on death.

Upon sale or upon death, the difference between the proceeds of disposition and adjusted cost base of a seg fund is taxable as a capital gain.

If you dispose of your seg fund for proceeds equal to or less than the adjusted cost base plus selling costs, you’ll have no net tax bill, even if a maturity or death benefit was paid. This is because you did not receive proceeds of more than you invested.

Segregated funds are known to have relatively high management fees in comparison to other traditional investments. Ensure that you fully understand the costs and benefits as they directly apply to your situation before purchasing them. Of course, this same statement should apply to any investment that you make!