One of the questions I was frequently asked was, “Should I buy life insurance protection?” The answer is that it depends!
If you are young and anticipate having a mortgage and a family, life insurance protection should almost be mandatory! No one would want to leave a family behind saddled in debt with a significant loss of income. But what about everyone else?
The answer depends on your age, sex, and ability to save.
Here’s my approach. I’ll look at two questions:
1) how much would I be worth should I pass at any age?
2) how much monthly cash will I receive after taxes, if I live to age 95? And
3) how many years until I’m indifferent between the two options?
Typical Life Insurance Scenario
So let’s look at the decision model using a younger person. Jim, male, age 24, has a first job with an income of $45k annually and is in a serious relationship. Jim can save $300 a month. His investments are going to return 6.25% annually so that we can compare the options.
If Jim invests in an RRSP and adds his tax return to the RRSP every year, then at age 67 (the current retirement age) Jim can buy an annuity paying him $58,851 annually. Using the BC tax tables, Jim nets $3,853 a month after paying his income taxes. If Jim decides to self manage his money, he converts the RRSP to a RIF netting 6% annually and his after-tax income rises to $4,187.
If Jim invests in a TFSA, then Jim’s non-taxable annuity pay him $3,967 a month, and the self-managed option would net $4,367. So at his current income level, Jim would be better to invest in a TFSA than an RRSP.
This is an interesting lesson. Most people would choose the RRSP because the pool of money is larger at age 67 ($1,059,927 to $873,339). But the net cash monthly after-tax is higher for the TFSA, and isn’t the most cash possible what we want from our retirement savings? The wise investor ALWAYS considers the taxes when withdrawing money from an investment.
So what about permanent insurance? Jim will fund his retirement with a bank loan using the cash value of the insurance policy as collateral. When Jim passes, the policy will pay off the loan, with the remaining going to Jim’s beneficiaries. At age 95, Jim’s policy will have a projected cash value of $3.8M. This funds a loan of $6,716 monthly. Since this is not income, there is no tax to pay. It looks as if Jim should buy the insurance. The death benefit of the insurance policy is projected to be in excess of $1.3M when Jim is 67. This is higher than the others because of bonus payments for longevity within the typical insurance policy.
But, what about the return rate? We’ve been saying in blog posts that you should be able to get better than 10% returns on investment over the long term. What does that do to the RRSP and TFSA?
Here’s where the third question comes in handy. Assuming the life insurance investments still only return 6.25% then the value in Jim’s RRSP will equal the life insurance death benefit in the year Jim turns 55. At this point, Jim is neutral between the two options. The TFSA will equal the death benefit 2 years later. Once the investments are larger than the death benefit, Jim’s family would be better off to have the investment. Right?
Again, the answer is “Maybe”.
Weighing Death Benefits vs. Investments
If Jim’s spouse is still alive, then the TFSA is available tax-free, so with a TFSA, Jim is neutral as of age 57. However, if his spouse predeceases Jim, then the TFSA goes to Jim’s estate and will attract considerable estate taxes. In this case, Jim will not be neutral until age 61. The RRSP also transfers to the spouse tax-free, but withdrawals from it are taxable. Jim would not be neutral until age 65. And if his spouse predeceases him, Jim would not be neutral until at least age 70.
If Jim were to start later in life – after 35 – the advantages of insurance start to reduce, and investments eventually catch up much sooner to the cash value. Also, there is a limit to the amount of investments allowed to be contained in an insurance policy (based on policy face value, and the insured’s age and sex), just as there are limits to TFSAs and RRSPs.
From this example, you can see that there are a number of advantages to insurance – which is why most wealthy families own as much of it as possible, and why 30% of the asset value in the US banking system is kept in insurance.
Want to know more? Contact me at firstname.lastname@example.org