Should clients cash out an insurance policy?

Clients who need access to cash will come to you for solutions.

If they have permanent life insurance, one option is cashing out the policy. But while it won’t affect future insurability, there’s a tax hit if a client surrenders his policy prior to death. That’s because permanent insurance policies (universal life or whole life) have an investment component that’s tax-sheltered. Pulling out cash early means the client will have to pay tax on that income.

Elli Schochet, an associate at Al G. Brown & Associates in Toronto, says the amount of tax clients have to pay depends on the ACB of the policy.

The ACB is determined through a complex CRA calculation, but in short, it’s made of the premiums put into the policy, less the net cost of pure insurance.

If the ACB is $20,000, and there’s $100,000 built up in a policy, the client would pay tax on the remaining $80,000 (see “Alternatives to access cash from a policy”).

And how long a client has had a policy makes a difference. “The best time to cancel and have the lowest tax impact is probably within the first few years,” says Schochet. “The longer the policy has been in place, the higher the percentage of the cash value that’s taxable.”

While the tax impact may be lower early on, Ashley Rodrigues, director, Insurance Solutions at BMO Insurance in Toronto, says it usually isn’t appropriate to cash out over the short term (see “Surrender charges explained”).

“If clients go back to the primary purpose of life insurance, they’re committing to a long-term plan,” he says. “If they’re going to access all the funds over the first few years after that policy goes in place, life insurance is probably not the best vehicle for them to do that.”

Cindy David, senior estate planning advisor at Raymond James Financial Planning Ltd. in Vancouver, agrees there are better options than a full surrender. “I often tell clients the last buckets they should spend from are their TFSAs, and any cash-value life insurance policies” because those buckets are growing tax-free both outside and inside an estate.

Surrender charges explained

Apart from tax consequences, clients who cash out a permanent policy early may also be subject to surrender charges (commonly called back-end charges).

Universal life plans have clearly stated surrender charges, says Cindy David, senior estate planning advisor at Cindy David Financial Group Ltd. “We know exactly what they are and how they affect cash value. And depending on which company the policy is with, those surrender charges can last either eight or 10 years.”

So if a client has a UL policy for less than 10 years, he’ll likely be subject to charges. David suggests an alternative to avoid the surrender charges is to take out a policy loan. For instance, if a client needs $50,000 to buy a boat, “I would say, ‘Let’s just borrow against it, ride out the surrender charge period, and then make a withdrawal to pay that loan.’ ”

Meanwhile, the surrender charges on whole life plans are a lot more complex, she says. “If you look at the cash value, the surrender charges are built in. They’re not disclosed. If you [cash out] $100,000, for instance, you may only get $25,000 back in year one on a whole life plan, versus $85,000 back on a universal life plan.”

Here are a few alternatives for cash-strapped clients with permanent life policies.

1 Opt for a partial surrender

Perhaps clients can make do with some cash in the policy. If that’s the case, they can do a partial surrender, which allows them to retain the insurance. Let’s use the same client example from above. The client has $100,000 built up in his policy and needs access to $30,000. The ACB is $6,000, so he’d be taxed on $24,000. Even though the amount that’s taxed is less, the percentage taxable is still the same at 80%.

Also, Schochet notes it’s easier to partially surrender a UL policy than a WL.

“In certain types of whole life policies, one of the dividend options uses the dividends to purchase paid-up additions of insurance,” he explains. “When you take a partial surrender by way of surrendering dividends, you’re also reducing the paid-up additions of insurance that were bought by those dividends. Over time, paid-up additions of insurance are added to the base coverage that was bought, which equals the total amount of coverage. When you surrender the cash value, it reduces the paid-up additions. So both the cash value and overall death benefit are affected.”

But say a client has $100,000 of cash value in a face-plus-fund UL policy (i.e., the cash value is paid out together with the death benefit on a tax-free basis), and the face amount of the insurance is $500,000. If the client dies, his estate would get a $600,000 death benefit, says Schochet. “If he takes out $50,000 in cash, he knows his estate will still get a $550,000 death benefit.”

2 Take out a policy loan

Both UL and WL allow clients to take out loans from the insurer, using the policy as collateral. The option lets clients access cash without surrendering their policies.

“You’re essentially borrowing from the cash value that you’ve built up in the policy with the objective of paying it back at some future point,” says Rodrigues. “This would allow the policy to continue to grow without disrupting any of the growth in the cash value that they’re borrowing against.”

But, clients will be on the hook for interest payments. And there’s still a tax consideration, because the loan is considered an advance payment of a policyholder’s entitlement for tax purposes.

Policy loans are first drawn against the tax-free ACB of the policy (it’s a withdrawal of the policyholder’s original capital, so the funds come out without tax consequence). Any amount withdrawn beyond the ACB is taxed as regular income.

Using the same example of a client with a cash value of $100,000, let’s say he takes out a $30,000 policy loan. “We said the adjusted cost base before the loan was $20,000,” says Rodrigues.In many member states you are also working at the overnight cialis tadalafil regional and in some cases provincial level too. Malaysian ginseng is one among the best erectile dysfunction pills is formulated using effective and safe to use just as levitra vardenafil generic ? And are the side effects of heavy duty medication is the loss of libido and for men, this can be especially disheartening. Acupuncture affects improve local resilience in the nasal mucous membranes, reducing excess mucus production, smooth air flow so that the flavors mempet lost, strengthen the lungs viagra properien article viagra on line cheap organ systems. herbalcureindia.com Therapy is performed 2-3 times a week, for 8-10 visits. When a man face trouble to express his sexual desire generico levitra on line then it demands for treatment.

“So the $30,000, less the $20,000, equals $10,000 that would be taxable income.” (If the loan was $15,000 instead, and the ACB was $20,000, there wouldn’t be any taxable income to report.)

“And if the loan is repaid, a tax deduction is available to the policy owner for the amount repaid, up to the taxable income declared when the original loan was taken (e.g., $10,000 in [the] former example),” says Rodrigues.

“The portion of the loan repayment in excess of the deductible amount claimed would be added back to the ACB of the policy. If the tax deduction is not claimed, the full amount of the repayment would be added back to the ACB.”

To be able to write off interest costs, the policyholder would have to be investing the loan proceeds.

Fun facts

Did you know J.C. Penney, Walt Disney and the Pampered Chef all borrowed from their life insurance policies?

JCPenney

Following the 1929 stock market crash, retail magnate James Cash Penney borrowed from his life insurance policies to help meet his company payroll. If he hadn’t come up with the cash, the company likely would’ve been forced to close.

Walt Disney

When no banker would lend him the money, Walt Disney borrowed from his life insurance in 1953
to build Disneyland, his first theme park.

The Pampered Chef

In 1995, Doris Christopher launched a kitchen tool company, the Pampered Chef, with a policy loan. In 2002, she sold her company to Warren Buffett’s Berkshire Hathaway for a reported US$900 million.

Sources: Creating an American Institution: The Merchandising Genius of JCPenney, Garland Publications, 1993; Mouse Tales: A Behind the Ears Look at Disneyland, David Koeing, 1995; The Pirates of Manhattan, Barry James Dyke, 2007. Via MassMutual Financial Group.

3 Use the policy as collateral with a third-party lender

Another way clients can get cash is to approach a bank or credit union.

Like before, the life insurance policy is assigned as collateral to secure a line of credit or a loan—but the lender is external.

While there is no taxable income, clients still have to pay interest, which can be higher than typical bank loans—the rate depends on the lender. And clients must get approved, so lenders will assess creditworthiness, as well as the collateral.

Schochet adds that, with WL, the bank loan generally cannot exceed 90% of the cash value; with UL, it’s 75% if it’s in guaranteed investments like GICs (50% if in equities).

Loan payment

Payment terms depend on whether the loan is from the insurer or the bank.

“The insurance company will normally require they pay interest on the loan during their lifetime, and the loan is paid off at death [with the death benefit proceeds],” says Schochet. “Banks have different arrangements and may allow the interest to be capitalized. So you don’t pay the interest during the period you’re alive—it’s accumulated until death.” For instance, if the policy has a $250,000 death benefit and the loan is $100,000 after interest, the estate would get $150,000.

David adds age plays a factor when borrowing. “If you’re in your 50s, [it may be cheaper to] just withdraw because you don’t want to be paying interest for 40 years. But if you’re in your late 60s, early 70s, I’d talk about borrowing.”

So it’s important for advisors to discuss all the factors, including why a client needs cash, as well as his age and the life of the policy. “Any sort of transaction needs to be evaluated,” says Rodrigues. “Life insurance should be a long-term commitment for estate preservation and wealth transfer. The savings account is the add-on, and shouldn’t necessarily be relied on for short-term purposes.”