Why holding index funds within a life insurance policy can be tax-efficient

Permanent insurance also has a host of other tax benefits

My first introduction to index-based investing was not with ETFs, but rather with index-based investment options in a life insurance policy.

Life insurance is often viewed as a means of providing financial security for loved ones in the event of one’s passing. However, what many people may not realize is that life insurance policies can also serve as a strategic investment tool, offering a range of tax benefits that can enhance wealth accumulation and preservation.

Leveraging life insurance for investment purposes can be prudent, particularly when considering the tax advantages. With the impending increase to the capital gains inclusion rate on June 25, life insurance has become more appealing for a variety of tax strategies and estate planning.

One of the most compelling aspects of using a life insurance policy as an investment vehicle is the potential for tax-free growth. Unlike many other investment options, such as taxable investment accounts or real estate, the cash value accumulation within a life insurance policy grows on a tax-deferred basis.

This means policyholders are not required to pay income tax on the growth of their investment within the policy, allowing their money to compound more rapidly over time.

When I purchased my universal life insurance policy more than 30 years ago, I was able to use index-related investment options to grow the cash value portion of my policy. This was beneficial because it was a simple and transparent way to grow these funds, while maintaining the diversification and the tax-sheltering from the policy.

While there are different options for building savings in a life insurance policy, there is no free lunch.

“The savings component in universal life policies is usually not guaranteed and may become negative,” cautioned Annie Belanger, insurance specialist with Raymond James. “It’s impactful since the cost of insurance (COI) needs to be paid monthly from the policy. Having to sell units at a loss to cover the COI is not recommended.”

However, Belanger said, if the policy is fully maximized and well-managed — for example, the policyholder sets aside several months’ worth of COI in a cash-like vehicle — “it can become extremely attractive. Whole life insurance is another type of permanent insurance that offers a growth component with minimum guaranteed cash surrender values.”

However, “any recommendation must be based on the customer’s situation. This approach is suitable for clients who have already maximized their RRSPs and TFSAs, and have no debt,” Belanger said.

Tax-deferred withdrawals

Policyholders of permanent life insurance policies can access the cash value of their life insurance policy through withdrawals or policy loans without triggering immediate tax consequences.

Withdrawals or loans are considered loans against the policy and are not subject to income tax as long the policyholder does not withdraw or borrow more than the adjusted cost basis (ACB) of the policy. (If that happens, the withdrawals would be subject to tax.) This feature can be particularly advantageous for individuals seeking supplemental income during retirement while minimizing their tax liabilities.

Estate planning benefits

Life insurance can be used to transfer wealth tax-efficiently after the insured dies. Upon that death, the death benefit is paid out to the designated beneficiaries tax-free, providing a source of liquidity to cover estate taxes, final expenses and other financial obligations.

A death benefit can help preserve the estate’s value and ensure that beneficiaries receive their inheritance without the burden of hefty tax liabilities.

“Life insurance provides the easiest and fastest way to receive liquidity as opposed to waiting for the rest of the estate to settle to access other type of assets,” Belanger said.

Tax-advantaged succession planning

For business owners and entrepreneurs, life insurance can serve as a powerful succession-planning tool with significant tax advantages.

Through corporate-owned life insurance policies, business owners can ensure a tax-efficient transfer of wealth to successors or key employees, providing financial stability and continuity for the business while minimizing the impact of taxes on the estate.

Furthermore, the premiums paid for life insurance policies may be tax-deductible for corporations, further enhancing the tax benefits of this strategy. Finally, life insurance owned by a corporation will help create a substantial credit in the capital dividend account to help flow tax-free funds out of the company to pay an owner’s personal tax, avoiding double taxation.

Tax-free access to funds

Another lesser-known tax benefit of life insurance policies is the ability to access funds through policy dividends. Participating whole life insurance policies often generate dividends, which policyholders can choose to receive as cash payments, use to purchase additional coverage or accumulate within the policy to enhance its cash value. These dividends are typically considered a return of premiums paid and are therefore not taxable as income, providing an additional source of funds for policyholders as long as the policy’s ACB is not exceeded.

Conclusion

Life insurance policies offer a myriad of tax benefits that can make them an attractive investment vehicle for Canadians seeking to grow and preserve their wealth. From tax-deferred withdrawals, estate planning advantages and tax-efficient succession strategies, the tax benefits of life insurance policies can significantly enhance overall investment returns, financial security and estate values when used in conjunction with a solid financial plan and appropriate investment oversight.