Yes, the life insurance industry is a tax haven, and will likely always enjoy that status, because of all the special laws created, just for it. You can spend time wondering why, or you can use their heavily favored status to your advantage.
One popular strategy is the life insurance tax shelter. In the last 10 years, Canadians have stuffed millions and millions of dollars in these programs. The reason is that they allow either tax-deferred or TAX-FREE treatment of your investment dollars, with no risk.
What is an insurance tax-shelter?
Simply put, an insurance tax-shelter is a plan issued by a life insurance company that allows you to deposit any amount of money and shelter all of the growth of the investment from income tax.
How does it work?
Revenue Canada allows insurance companies to issue these plans and maintain their tax-shelter status as long as they satisfy certain conditions.The insurance company must maintain a minimum amount of insurance on each plan to keep it tax exempt. The insurance however, can and should be low cost decreasing coverage, only enough to keep the plan tax exempt. The amount is based on a Revenue Canada formula and each plan must meet an annual test.
What makes the strategy work?
Why do these plans out perform other non-sheltered investments? Your earnings build-up TAX-FREE within the plan. The annual expense charges of the plan cost less than the tax which would have to be paid on the investment earnings of a similar investment such as GICs, bonds,etc.
Example: Assume an 8% annual rate of return. A couple, both age 45, in a 50% tax bracket would have to pay a total of $43,244 of income tax on the earnings of an investment of $10,000 per year for 10 years. In contrast, if they invest $10,000 per year for 10 years into a tax-sheltered insurance account, earning the same rate of return, they would pay only $10,701 in total expense charges (including insurance cost) to the insurance company over the 10 years. The plans are flexible, allowing you to vary the amount of you deposit, and choose the investment type of the plan from GICs to investment Index Fund.
How do you get your money out?
When it comes time to take income, you can take income from your plan one of three ways. Here are two income strategies for Canadian residents (for tax purposes). Make direct withdrawals from the tax-deferred account and receive part of your income TAX-FREE.
Under special arrangement, you can leverage the account with a bank. The bank will take your plan as a security loan. You can then make a single loan or a series of loans as income. The bank will capitalize the loan payments, so you will never have to make payments. The loan is repaid from the TAX-FREE insurance pay-out, when you die. The insurance pay-out in excess of the bank loan balance is then paid out TAX-FREE to your beneficiaries. Since a loan is not taxable, you can earn all of your income TAX-FREE.
By comparison, if you tried this with your RRSP, your financial institution would be forced to withhold 25% and send it to Revenue Canada.