The Best Tax Shelter

Thanks to the extensive legislative protection, all insurance industry products enjoy some degree of tax advantage.

Some of these however, are more effective than others and if you have income worth sheltering from taxes, here they certainly find their refuge.

The funds invested in these insurance products are enjoying tax-deferred, or often tax-exempt status. As well, there is often a guarantee to eliminate any risk.

What could be better than a tax-free investment without any risk?

So, What is It?

Although each insurance company issues them under some proprietary name, these insurance policies are all similar in that they are a combination of some insurance and some investments. The proportions of the two are up to you to some degree. The growth of the investments is completely sheltered from income tax.

Because these plans are not just insurance, nor just investments, but a combination of both, they are called Universal Life policies.

The Way it Works

Based on the rules of the Income Tax Act, sections 12.2 and 148, Canada Revenue Agency (CRA) permits the insurance company the tax-exempt status of the policy, as long as some conditions are satisfied. The company must keep in force a minimum amount of life insurance in exchange for the tax-exempt status. But, this insurance is really kept to the minimum, just enough to satisfy the conditions of tax-exempt status. The amount of the minimum is determined by a formula provided by CRA and every policy is matched, or if necessary, adjusted to this formula yearly by the company.

The Advantages

The second advantage is that the cost of the policy is much less than the taxes would be, payable on the gains of a comparable, non-registered investment.

An example: assuming an 8% yearly return on the investments, a 45 year-old couple in the 40% tax bracket, would pay $22,582 income tax on the earnings of annual $10,000 investments during a ten year period. But if they invested the same amount in a Universal Life policy, under the same conditions, they would only have to pay approximately $11,000 to the insurance company. This is an extra 10% gain.

The third advantage is that these plans are flexible in the sense that the owner of the policy can not only choose how much money will be deposited in the policy above a certain minimum; but also when, how often and how long. At the same time, the insurance company provides the guarantees.

The flexibility is in the policy owner’s favour.

The money can be placed into any combination of dozens of different types of investments within the policy.

Taking your money out

The accumulated money is available to you in two ways when you need it.

At first, you can withdraw all the money you put in before, less the cost of insurance: the “Adjusted Cost Base” (ACB). These withdrawals are tax-free. The insurance company calculates the total of the ACB for you. This protects you from going beyond the tax-free limit.

The true benefit of this strategy becomes obvious at the time of leveraging the remaining money in the policy. This is an agreement with a bank for the leveraging of the policy. Simply, the bank advances a loan, whose amount is calculated to use up all the money you want to use up from the policy. The loan can be paid to you in monthly or yearly installments, or even in one lump sum. These loans are always tax-free. In the meantime, the investment left behind inside the policy continues to earn returns also tax-free.

Leveraging Your Policy

The leveraging agreement with the bank will make your policy the collateral for the loans. Since the bank would capitalize the loan payments, you will never have to pay any of it back, unless you want to. The same happens to the loan interest. In fact, you receive all the payments tax-free, while the bank is willing to wait for repayment, because the growing investments in your policy provide enough security. The repayment of the loan will be from the tax-free death benefit of the policy, whenever the time comes. The amount left over after the loan is paid back will go to your beneficiaries, also tax-free.

So the income you derived from the loan was all tax-free, and so is the death benefit: tax-free.

If the accumulated money was not used up by the time of your death, the remaining balance and the life insurance benefit both are paid to your beneficiaries, without any probate process and, again, tax-free.

To show the actual effect of the powers of this strategy, I borrowed the following example from David Voth

As this example shows, the Universal Life policy has the potential to provide 10 times more money for your family than an RRSP would.
If you are alive twenty years hence nothing will provide better retirement income to you. But should you not live that long, nothing would provide more to your family. In either case, all payments will be tax-free!