Universal Life – When and Why?

Over the years there has been much debate between insurance sales people offering their advice on Universal Life Insurance.  You’ve no doubt heard the “buy term and invest the difference” company say that it’s always better to buy term insurance and invest your extra cash flow in a solid investment portfolio.  You may have also heard those who only sell Universal Life Insurance saying, “UL is the only way to go”.  In reality both are right…and wrong.  Many “insurance advisors” (using the term loosely) have a system, or a particular product or strategy that they attempt to fit each client into.  For example, the folks who say that buying term is the best way of doing things would never suggest a Universal Life product, even if a UL were the best option.  Their system/bias prevents them from considering other options.  In this article I would like to lay out the basics of when a UL product should be considered and when it shouldn’t.  The details of a Universal Life Insurance strategy are different for each client and can be extremely complex so I’ll go into more comprehensive strategies in future articles.

When Should a Universal Life policy be considered?

Universal Life is a tax planning product and she be used with a sound tax plan.  In Canada we pay plenty of tax and it’s what the greatest percentage of out income goes towards, more than any other single thing, making it vital to have a tax plan.  A tax plan consists of ways to plan for and help lower your tax expense in legitimate ways (i.e. RRSPs, TFSAs, income splitting, etc…).  But before we get into the tax benefits of Universal Life Insurance we need to talk about criteria #1;

1.) Is There a Need for Permanent Insurance? – Because life insurance has a cost, there should be a reason or need that justifies the cost.  Whether it’s a need to protect assets in the estate or to provide for loved ones, there has to be some sort of identifiable, quantifiable “insurable need”.   Insurance need aside for a moment…because the costs can be quite high it’s advisable to take advantage of all other inexpensive tax saving vehicles (i.e. RRSPs, TFSAs, etc…).  This leads us to criteria #2;

2.) Have RRSPs and TFSAs Been Fully Employed? – For individuals (unincorporated entities) an RSP and TFSA will allow you to have tax-deferred (RRSP) and tax-free (TFSA) growth.  Using these tools can help to save thousands of dollars annually.  If these vehicles have been fully employed or unavailable (corporations), then we move to criteria #3;

3.) Are There Long-Term Unregistered Cash Assets? – Unregistered assets that are invested can attract significant taxes annually (capital gains, interest income, dividend) and care should be taken.  A universal life product can shelter all investment growth from tax if designed properly.  For example; incorporated small businesses in Canada pay nearly 48% on all investment income, if the corporation had $100,000 invested in a 10-year bond at 5%, then they would have to report income of $5000 in that fiscal year and pay tax of $2,400.  Making the after tax rate of return 2.6%.  In a Universal Life product you can expect there to be additional “management fees” on a similar investment (0.5% in the case of a bond portfolio), so let’s assume that we can only get 4.5% on 10 year bonds.  Because the growth is completely tax-free, the corporation’s investment grows by $4,500.  The Universal Life investment outperforms the alternative by $1,900 (or 1.9%).  Compound this effect each year for 10 years and the Universal Life investment has $155,000 and the alternate has only $129,000 (assume annual coupon pmts).  That’s an additional $26,000, which is almost twice as much growth as the alternate.

If the costs of insurance are too high or the rate of return too low, then the advantage of the tax-sheltering is gone and the invested cash will be depleted over time.  This brings us to the last criteria:

4.) Are the Taxes Saved More than the Cost of Insurance? – Initially the costs will be higher than the taxes saved.  But the goal is to save more in taxes than the actual insurance costs in the long term.  This is like having “net free insurance”.  If your advisor shows you rates of return in excess of 6% or 7% in a Universal Life policy then be cautious because the underlying investments often have a traditional MER and a UL fee, which may make the higher returns unrealistic.  If 3% – 6% is used and the projections are still satisfactory, then there will be a less likelihood that you will need to bail out the policy with future deposits to keep it afloat.

My Two Cents…For What it’s Worth – if you’re not sure about Universal Life or Term Insurance and which one is best for you, then start with Term.  You can always convert it to a Universal Life Plan without medical questions and your costs will be low while you decide.  You can also cancel at any time without a penalty.  Universal Life can’t be scaled back into a Term policy and if you cancel it you may end up forfeiting a significant part (or all) of your deposit.  If your answer is “YES” to all the criteria, 1-4, then Universal Life might be an excellent option.  Consult your tax professional with your insurance advisor to implement a strategy that will be to your advantage.

By Jonathan at www.CanadianLifeQuotes.com and www.IntegralFinancial.com




*This article is for information purposes only and is not intended as specific advice for any individual.  Please review your policy contract for complete details of your existing coverage and speak with a licensed professional if you have any questions or concerns.

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