Using whole life insurance for tax-free income in retirement

Your agent earned a commission when he first sold you the policy 30 years ago. Using today’s pricing as an example, a 35-year-old male purchasing a $100,000 whole life policy will have a premium payment of about $143 per month. The agent will earn about $2,401 in the first year, $86 per year for the next two years, and then $34 per year until the policy is no longer in force. At $34 per year in commissions, your agent is not benefiting in the way you may suspect.

What may surprise you is that if you transfer your policy to another agent to help you, the original selling agent continues to earn $34 every year, and your new agent earns nothing. To be fair, the new agent can go to the original agent and ask them to “please sign over the future commissions.” This doesn’t often happen, though.

Should you cash out your policy?

When policy holders, like yourself, don’t feel they have received the help they need from an agent or insurance company call centre, they can sometimes take matters into their own hands and do as you are thinking: cash out by surrendering or cancelling the policy. This is referred to as a policy lapse, which is good for the insurance companies and existing policy holders. The insurance companies benefit because they don’t have to pay out the larger death benefit, and some of those savings are reflected in the dividend scale (or returns) on existing policies.

You may hear an agent talk about a company’s dividend scale as a rate of return and assume it refers to your policy’s growth rate, like with investments. However, that is not how it works. On Sun Life’s website, for example, the company says: “The dividend scale interest rate isn’t the return that a client can expect from their policy.” It goes on to say the growth rate is influenced by a number of different factors, including the number of premiums paid to the policy and the insured person’s age and risk characteristics.

Alan, when your policy was designed, interest rates were higher, and the business environment was different than it is today. I suspect if things remained exactly as they were 30 years ago when you purchased the policy, it would be performing close to what the agent suggested. Times changed and the policy has been affected. I could say the same thing about other investments and tax strategies. This is why it’s important to incorporate different and flexible strategies, including life insurance strategies, into your long-term plans.

Borrowing against the cash value for tax-free income in retirement

I don’t understand why you’re finding it hard to borrow against the policy, because banks and other third-party lenders do lend against the cash value of an insurance policy. Just like with any other loan, you must qualify, and banks often like to see that you have an income. As a retired corporate business owner, do you have an income or only investments? Is it possible you’re having difficulty getting a loan because you’re not showing an income?

You can get tax-free income by borrowing against the policy using a third party for the loan. Although tax-free sounds good, tax is just one type of cost. Instead of thinking tax-free, think cost-free. You will realize that borrowing against a policy for income is not cost-free. Cumulative interest costs on the loan negatively impact the insurance death benefit, the most valuable part of a life insurance policy. 

So if you do not want anyone or a charity to receive the death benefit, I can understand why you’re not sure what to do with the policy. My suggestion is to ask your agent to create a proper plan showing you how your policy fits into your future. As you are doing the planning work, see what happens if:

• You surrender the policy, take the cash, and pay the tax.
• You borrow against the policy for income.
• You borrow against the policy to invest, so the loan interest is tax deductible.
• You donate the policy to a charity and claim a tax credit.
• Someone comes into your life, such as a new partner

Knowing you have a tax-free death benefit as a backstop, would you have more freedom to spend more, borrow from your home equity or ease worries about long-term care costs, knowing the money will someday be replaced? Your answer will help you make planning decisions.

Seek the right expert advice

Alan, life insurance is an interesting financial product that provides some guarantees, tax advantages and options. But, before cancelling your policy, it’s worth talking to a planner to see what you can do with it, especially after paying all these years and getting it at low cost because the policy was purchased when you were young.

Read more about life insurance:

• Do I really need life insurance?

• Should seniors cancel their life insurance policies?
• Infinite banking in Canada: Should you borrow from your life insurance policy?
• Should you buy life insurance to pay for tax owed upon death?

About Allan Norman, MSc, CFP, CIM

With over 30 years as a financial planner, Allan is an associate portfolio manager at Aligned Capital Partners Inc., where he helps Canadians maintain their lifestyles, without fear of running out of money.

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