What are the ins and outs of using a whole life policy to cover tax liability?

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By Julie Cazzin with Allan Norman

Q: I have a whole-life policy I bought 34 years ago. It has paid dividends/cash value, the principal amount is $100,000 and I pay a premium of $1,000 per year. The life insurance amount has grown to $300,000 through dividends paid as well as cash value. I am currently in the process of estate planning and wondering if it makes financial sense to increase the principal of this life insurance. Is it possible? Or is it a better option to just buy a life insurance (or other) policy? I am 62 and would like to increase this policy to cover taxes at death, but I wonder what is the best and cheapest to do this at this age. — Thank you, Julia

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FP’s answer: Hi Julia. You will not be able to add additional life insurance to your existing policy. You can reduce the death benefit on your insurance policy, but not increase it.

Your question got me thinking: What are your reasons for wanting to cover your taxes at death? It sounds like you should do it, and life insurance is often presented as a solution to doing so, but should it cover your taxes on death?

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If your taxes are the result of a retirement income fund (RRIF) account or capital gains in an investment portfolio, you can pay taxes on the investment proceeds. Buying an insurance policy means having less money when trying to build a bigger home for your heirs.

On the other hand, if you have rental properties, cottages or other assets that you don’t want to sell, you need to cover your taxes and an insurance policy can be the best solution. Before jumping into insurance, estimate the projected value and associated taxes of your assets upon death. Is there anything in your estate that you don’t want to be liquidated or divided equally among your heirs?

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Will there be enough money to cover the taxes when everything is liquidated and turned into cash so you can keep the assets you don’t want to sell and equalize your estate? For example, this is the case if you leave the Cottage for, say, Maria and compensate Bill.

If your future liquid assets are enough to cover your taxes, you may not want insurance. My colleague, Jeff Cait, an insurance specialist, might ask, “But do you want to die neatly?”

Relying on selling assets with anticipated future value can be messy. You may have some tax-free assets (home, tax-free savings account), taxable assets (RRIF) or assets paid outside of your estate with a taxable estate (RRIF). The value of the assets may be different than expected and it may take longer than expected to sell the assets and to complete the property. There may be conflicts with the heirs.

Using insurance adds certainty to estate planning. What options do you have with your existing policy? The original death benefit on your policy was $100,000 and has increased to $300,000, and will continue to grow as long as you are alive and paying premiums. Find out how much you can grow by requesting three policy illustrations from insurance companies.

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• Continue to pay premiums;
• Balancing the policy on the anniversary date, which means there is enough money in the policy to pay the premium on its own, although it is not guaranteed to be able to pay itself forever;
• Balance the policy on the second anniversary date.

If you keep paying the premium, what is the death benefit of the policy at the anticipated death, and will the amount cover the anticipated taxes in the future?

If you balance the policy and stop paying the premium, it may grow a little, and you can redirect the current premium to the new policy. Having a second offset illustration allows you to measure the value of one premium payment over another in the projected death benefit. This will help you decide if you should continue making premium payments.

A new $300,000 whole life policy has a premium of about $12,000 per year, or if you go for a 10 or 20 year term, the premium is about $1,600 per year and $3,000 per year.

With whole life, you know the money will be available to cover taxes, while with term, once the term is over, it’s over, unless you renew for a new term or convert to a lifetime or permanent policy. But the option is only allowed up to a certain age, and the term eventually expires.

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Julia, what about your tax problem? Is it as big as you think? Do you have to cover everything? If you had to cover all taxes, what would be your choice? If by using insurance, how can you use your existing policy? If you choose a new policy, do you want to commit to a whole life policy or just hedge your bets by using your existing policy and some term insurance that can be converted if desired?

Allan Norman, M.Sc., CFP, CIM, provides financial planning services and certified fee-only insurance products through Atlantis Financial Inc. and provides investment advisory services through Aligned Capital Partners Inc., which is regulated by the Investment Regulatory Organization of Canada. Allan can be reached at alnorman@atlantisfinancial.ca.

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