Sometimes the best intended plans don’t always work out as designed (road-trip to the Okanagan with a toddler, anyone?). As financial planners, our job is to scrutinize financial strategies from multiple perspectives before making recommendations. In our last article, “AR: Augmented… Retirement”, we explored how the substitution of traditional investment assets with a participating whole life policy would not only net significant after tax gains in the estate, but would also produce substantial cash value. In this article, we will discuss how to access that cash value in the need of an emergency or for general lifestyle funding.
In this scenario, Jack & Jill Carpenter invested $26,667 a year for twenty years for a total of $533,340. However, the estimated cash value using the current dividend scale totals only $436,344 at the end of those twenty years. It is important to note that this policy was designed with the intent of generating large estate values in the later policy years, and it wasn’t the clients intention to access cash early on. Therefore, although possible, this policy isn’t a great option for funding lifestyle or expenses within the first two decades. If Jack & Jill believed they might need some or all of their premiums within the first 22 years (roughly the break-even point for cash value and premiums paid) of the policy, they would be better to consider traditional fixed income investments.
After about the 19th year of the policy, the cash value begins to grow substantially and accessing some of that cash may be easier to recommend. By the end of the 40 year projection, the cash value is about $1.75MM. When we compare the value of the remaining traditional investments in the two scenarios, standard and augmented (before tax, in the last year of the projection), the difference is about $1.5MM. This means the cash value grows at a greater overall return than traditional assets would.
Suppose Jack & Jill needed to access some of their cash value in the policy for an emergency expense, there are a couple options to consider:
- Make a withdrawal from the policy. Also known as a partial surrender, the Carpenters could take money out of the policy in cash. Any withdrawals made in a situation where the cash value is greater than the adjusted cost base (ACB) of the policy will be taxed as passive income. Tax treatment is based on a proration: If the ACB is 30% of the total cash, then 30% of the withdrawal is tax-free and the rest is taxable. The corporate passive income tax rate in Alberta is 48.7%, which means this could be a heavy bill to pay. A withdrawal in the early years of the policy is a bit safer as the ACB is greater than the cash value. After year twenty, cash value becomes greater than ACB and withdrawals will become taxable.
The size of the withdrawal matters in other ways too. Withdrawals that include guaranteed cash values will reduce the face value of the death benefit. Withdrawals of dividend cash value will reduce the size of paid up additions. Both types of cash withdrawal will reduce future cash values and future death benefits. As an emergency procedure, a withdrawal has merit and the client should always be aware of this possibility. However, given the possible tax implications and reduction in insurance benefits, it is best for Jack & Jill to look for better options.
- Policy loan. A better option for Jack & Jill is to receive cash from the insurer in the form of a policy loan. In this strategy, no money comes out of the policy and so the policy will continue to grow as designed. However, policy loans are charged interest and, therefore, until repaid, grind away at net cash value and net death benefit. Cash received by policy loan is tax free up to the ACB of the policy. As the loan is paid back to the insurer, a tax deduction is available for the amount of the taxable income which was declared in the loan above the policy ACB. Any amount outstanding after death is subtracted from the amount paid to the beneficiary.
- Collateral assignment. A final strategy for Jack & Jill to gain access to their cash value is through a loan from their bank. Unlike a policy loan which is issued by the insurer, a collateral assignment is a loan written by a bank that uses the cash value as collateral. Whereas a policy loan attracts tax for amounts greater than the policy ACB, a loan from your financial institution attracts no tax regardless of the amount borrowed. Canadian Western Bank will apply standard lending criteria when considering these loans and in some cases may lend as much as 100% of the cash surrender value. These are typically structured with a variable loan rate with no repayment of loan principle or interest being required until death. Collateral assignment is generally an optimal strategy for amounts larger than $500,000, due to loan pricing and the absence of tax for amounts below the ACB in a policy loan.
This strategy carries greater risk than a partial surrender or a policy loan in that if the loan interest rate is higher than the growth in cash value, the loan balance may exceed the margin that the lender has allowed. If the loan cannot be serviced to bring the balance back below the permitted margin, the lender may call the loan. In the worst case, a policy may need to be collapsed which would result in a taxable disposition and the loss of coverage.
Regardless of a policy loan or withdrawal, the Carpenters must be aware of possible shareholder and deemed taxable benefits. Since the policy is held within their company, Jack & Jill cannot simply take a loan and start spending to support their lifestyles. First, the money must be removed from the company and received in their personal hands. One possible way to do this is by a shareholder loan from the company to Jack & Jill. This loan can take advantage of the newly lowered prescribed rate of 1% per year. While the discussion about how best to receive money from the company into personal hands is beyond the scope of this article, it’s important to note that an additional mechanism must be employed to actually spend the money received from a partial surrender, policy loan or collateral assignment. In fairness, this mechanism would be no different than taking money from a corporate investment portfolio or bank account.
The Carpenters have a number of options available to them when it comes to accessing the cash value of their policy. Their desire to do so and the possibility that they may wish to access the cash value is an important part of the financial planning and insurance strategy design. With the coordination of an experienced insurance professional, our Senior Planners will help lead discussions and design a retirement cash flow strategy that can optimize estate value. Fill out the form below and one of our team members will be in touch.
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