Understanding Cash Value Life Insurance In Canada

Cash value life insurance is a type of permanent life insurance that includes a death benefit and a cash value component. Unlike term life insurance, which provides coverage for a specific period, cash value life insurance remains in force for the policyholder's lifetime as long as premiums are paid. This more comprehensive coverage offers both a financial safety net for beneficiaries and a savings or investment vehicle for the policyholder. The cash value of a life insurance policy is meant for the policyholder to use during their lifetime and can be accessed in several ways, including borrowing against it, withdrawing it, or surrendering the policy for the cash value.

How to withdraw from the cash value

The cash value of a life insurance policy can be accessed by the policyholder during their lifetime, providing a versatile financial resource that can be used for various purposes. Here are some common methods for withdrawing from the cash value:

• Borrowing against the cash value: Policyholders can borrow against the cash value, typically with favourable interest rates. These loans do not require credit checks and can be used for any purpose, such as paying premiums or covering personal expenses. However, these loans will eventually need to be repaid, as they diminish the overall death benefit or cause the policy to lapse.
• Direct withdrawals: Policyholders can make direct withdrawals from the cash value, which are generally tax-free up to the amount of premiums paid. Any amount withdrawn above this may be taxed. Withdrawals may also reduce the death benefit by an amount greater than what is withdrawn, depending on the specific terms of the policy.
• Using cash value to pay premiums: The cash value can be used to cover future premium payments, reducing out-of-pocket costs. This can be especially useful during retirement, as it maintains the policy while avoiding drawing from pension or retirement savings.
• Surrendering the policy: Policyholders can choose to "surrender" their insurance policy, essentially terminating it and receiving the full cash value. However, this option often comes with penalties, fees, and taxes, especially in the early years of the policy. Surrendering a policy means giving up the death benefit, so it should be considered carefully.

It is important to note that the specific terms and conditions for withdrawing from the cash value may vary depending on the insurance provider and the type of policy. Policyholders should carefully review their policy documents or consult with a financial professional to understand the specific rules and potential implications of withdrawing from the cash value.

Pros and cons of cash value life insurance

Cash value life insurance is a type of permanent life insurance that includes a death benefit and a cash value component. It combines the traditional death benefit with an investment or savings element. Here are some pros and cons of cash value life insurance:

Pros:

• Lifelong coverage: Unlike term life insurance, cash value life insurance provides protection for the entire life of the policyholder as long as premiums are paid.
• Tax-deferred growth: The cash value component grows on a tax-deferred basis, allowing savings to accumulate more efficiently over time.
• Access to cash value: Policyholders can access the cash value through loans or withdrawals, which can be used for various purposes such as funding education, supplementing retirement income, or covering emergencies.
• Guaranteed savings growth: Whole life policies often guarantee a minimum growth rate for the cash value, providing stability and predictable returns.
• Financial flexibility: The ability to borrow against the policy or use the cash value to pay premiums provides financial flexibility.
• Estate planning advantages: The death benefit is generally paid out tax-free to beneficiaries, making it an effective tool for estate planning.

Cons:

• High premium costs: Cash value life insurance is significantly more expensive than term life insurance, making it less accessible for individuals on a tight budget.
• Slow initial growth: In the early years, most of the premium goes toward administrative costs and the death benefit, resulting in minimal cash value accumulation.
• Complexity: Understanding how cash value grows, loan terms, and surrender charges can be confusing.
• Opportunity cost: Premiums paid into the policy may yield lower returns compared to investing the same amount in higher-performing investment vehicles.
• Surrender charges: Cancelling the policy early can result in significant surrender charges, reducing the available cash value.

Whole life insurance

The cash value of whole life insurance is a savings account that grows over the course of the policy. It is funded by a portion of the premiums paid by the policyholder. This money typically increases over time due to interest and investment earnings. Policyholders can choose to withdraw the cash value or use it as collateral for loans. The cash value grows on a tax-deferred basis, meaning taxes are not paid until funds are withdrawn.

The cost of whole life insurance is generally higher compared to other life insurance plans, such as term life insurance. This is because it offers lifelong protection and guaranteed premiums, regardless of age or changes in health. However, some whole life insurance policies may offer the option to pay for coverage over a shorter period, such as 10 or 20 years, which can result in higher premiums.

Universal life insurance

The premium of a universal life insurance policy is used for three things:

• Funding the policy's death benefit and covering the cost of insuring one's life
• Paying policy fees and other charges
• Funding the cash value account

The cash value of a universal life insurance policy can be accessed by the policyholder during their lifetime, providing a versatile financial resource. Policyholders can borrow against the cash value, take direct withdrawals, or use it to cover future premium payments.

There are several types of universal life insurance policies, including:

• Indexed Universal Life Insurance
• Variable Universal Life Insurance
• Guaranteed Universal Life Insurance

Indexed universal life insurance links the cash value growth to a stock market index, such as the S&P 500 or the S&P/TSX Composite Index. This provides an opportunity for cash value growth based on market performance, with some level of protection against market losses.

Variable universal life insurance allows policyholders to invest the cash value in various sub-accounts, similar to mutual funds. These accounts contain investments of the policyholder's choosing, so it is more of an investment product. The cash value and death benefit can fluctuate based on the performance of these investments, but the policyholder can set hard limits on the minimum and maximum values.

Guaranteed universal life insurance is a form of whole life insurance that does not require a medical exam or health questions, ensuring that coverage cannot be denied. While it may build some cash value over time, the coverage amounts are typically modest, resulting in a relatively small cash value. This type of policy often comes with a graded death benefit, meaning that if the insured person passes away within the first two or three years (unless due to an accident), the beneficiaries will not receive the full payout.

Variable universal life insurance

• Investment Options: Policyholders can allocate the cash value of their VUL policy among various investment options offered by the insurance company, allowing for potential growth based on market performance. The selection can be adjusted over time according to the policyholder's investment goals and risk tolerance.
• Flexible Premiums: VUL policies offer flexibility in premium payments, allowing policyholders to choose how much and when to pay premiums based on their financial situation.
• Adjustable Death Benefits: Policyholders can adjust the death benefit amount, subject to insurability and policy limits, providing increased flexibility in planning for financial protection needs.
• Cash Value Accumulation: The policy's cash value can grow based on the investment performance of the selected options, minus any management fees and expenses. Policyholders can borrow against the cash value or make withdrawals, although this may reduce the death benefit.
• Tax Advantages: VUL offers tax-deferred growth of the cash value, and the death benefit is generally paid out tax-free to beneficiaries.
• Risk and Reward: The investment component of VUL introduces a level of risk, as the cash value and death benefit can fluctuate with market conditions. While there is potential for higher returns compared to fixed investment options, there is also the risk of losing cash value in poor market conditions.
• Fees and Charges: VUL policies typically involve various fees, including administrative fees, mortality charges, and fees associated with the underlying investment options.

VUL is suitable for individuals seeking life insurance coverage with the added benefit of potential cash value growth through investments. It is particularly appealing to those comfortable with investment risk and who wish to have more control over the investment decisions within their life insurance policy. However, due to its complexity and the risks associated with the investment component, individuals should carefully consider their financial goals, risk tolerance, and the costs associated with a VUL policy before making a decision.

Frequently asked questions