Yes. (Hint… it’s all about your taxes)
We’re back with Alison Hughes, Director of National Distribution at Lawyers Financial. In our first conversation, Hughes laid out the differences between term life insurance (the kind of insurance you rent) and permanent life insurance (the kind of insurance you own). Today, Hughes explains some of the tax-efficient reasons why you might choose permanent life insurance if you’re one of 17,000 Canadian lawyers who’ve incorporated their practice.1
Incorporating advice. The bold decision to incorporate is a separate conversation. For now, we’ll assume that 1. You’ve already made that decision and 2. It’s the right decision, and we’ll fast-forward to some of the tax-efficient ways you can use permanent life insurance within your corporation to help you build long-term wealth. Here goes.
Q. Alison, what are some key reasons for buying permanent insurance inside my corporation?
A. Each situation is unique but important benefits include tax efficiency, tax-sheltered growth of the cash value component of the policy, and the lump sum, tax-free payment to your corporation when you die. Permanent life insurance can also help preserve your annual small business deduction if you have a growing amount of retained earnings in your corporation.
Q. Can you give us an example of tax efficiency?
A. If you’re incorporated, your professional income is paid into your corporation. In many instances, corporate tax rates are lower than personal tax rates, especially for high-income earners.
When you buy corporately owned permanent life insurance, you’re the insured person, but your corporation owns the policy, pays for it, and gets the payout when you die. So, where does tax-efficiency come in? For one, when your corporation pays your premiums, it does so with dollars that are taxed at corporate rates, not personal rates. This can yield significant tax savings over the life of the policy.
“Gains inside a permanent life insurance policy aren’t considered passive income, so there’s no impact on your small business deduction.”
Q. And what about the potential for tax-sheltered growth?
A. Let’s say you buy a corporately owned participating whole life insurance policy. This type of permanent life insurance has two components: the death benefit and the cash value—both of which grow every time you pay your premium.
The tax benefit here is that your regular premiums are pooled by the life insurance company into a large, professionally managed “participating account” with other policyowners. Participating accounts can have millions and even billions of dollars invested, depending on the life insurance company you’re working with. Many participating accounts pay dividends, and any growth in these pools is tax-sheltered.
At first, the cash value of your own policy will be relatively low. You’re new to the plan, you’ve just started paying premiums. But every premium deposit you make increases the cash value and death benefit of your policy and may attract greater dividends, the way a magnet attracts metal.
If you’ve already maximized your personal RRSP and TFSA contributions, there may be advantages to allocating after-tax corporate dollars to the participating account. We have some amazing planners on our team who can help you decide if this makes sense for you.
Q. How does my corporation access that cash value potion of my account while I’m alive?
A. There are basically three options:
- One, partial or full withdrawal of funds.
- Two, take a policy loan against the cash value from the insurance company.
- Three, use the policy as collateral to get a loan from a third party, such as a bank.
CRA views options one and two as deemed dispositions that may create tax consequences. But using the policy as collateral for a bank loan isn’t considered a disposition. So, option three doesn’t trigger taxable consequences. Think about it this way: you don’t pay tax on borrowed money. It’s also important to note that option three doesn’t affect the projected growth of the participating account.
Q. What happens to the cash value if I never access it?
A. When you pass away, the beneficiary (your corporation) receives the death benefit, which is projected to be far larger than the cash value. Depending on the specific policy terms, the cash value may or may not be included in the death benefit payout, but either way you’ll be well aware of how the benefit is paid when you work with your advisor to choose the best type of plan for your situation.
Q. Does growth in the participating account have an impact on my corporate small business deduction?
A. No. When you leave money in your corporation, known as retained earnings, it makes sense to invest it. Typically, money generated from those investments, including dividends, interest, and 50% of any capital gains, is considered “passive investment income” by CRA. Any passive income above $50,000 a year starts eroding the small business deduction that’s one of the benefits of incorporating in the first place. The tax consequence can be significant. But gains inside a permanent life insurance policy aren’t considered passive income, so there’s no impact on your small business deduction.
We can help.
Connect with a certified financial planner from Lawyers Financial for practical advice about one of the biggest decisions in life—insurance or otherwise.
Written for Lawyers Financial by Chris Goldie, a Toronto-based financial writer and editor.
Source: 1. Statistical Report of The Federation of Law Societies of Canada, 2019
