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Whole Life Insurance Part II: The Spending Game

This post is by Brian Poncelet, an insurance specialist and independent certified financial planner (CFP) who has been working in the financial services industry for almost 20 years.

Life insurance isn’t just for young families – it can be beneficial to retirees, too.  Nearly 25% of Canadians are expected to be senior citizens by 2036, yet they are leaving themselves financially vulnerable by taking on greater risk to achieve higher returns. Saving for retirement is only half the battle – spinning down your money in a tax efficient manner is just as important. Longer life expectancy combined with a prolonged low interest rate environment spells trouble for retirees, who risk outliving their nest egg and achieving poor rates of return.  With permanent life insurance, not only will you have more money in your pocket after taxes, you’ll also have better insurance protection.  Let’s walk through an example.

Recap

Do you remember Part 1?  Part II continues where Part I left off:  You Think Term Always Beats Whole Life Insurance?  Think Again!   Recall in Part I, there are two good friends, Allen and Bob.  Both are 35 year old males and breadwinners of families with a solid annual incomes of $100,000.   Both have similar insurance needs – except at age 35 Allen goes along with conventional wisdom and buys term insurance and invests the difference.  Meanwhile his buddy Bob also buys term insurance but instead supplements it with a whole life policy.  As we illustrated in Part I, the lower the rate of return, the further ahead Bob is.

Here in Part II Allen and Bob have reached retirement age 65.  Let’s assume they are both able to achieve a more conservative rate of return of 5% (as opposed to 7% in Part I).  Inflation is 2% and the average tax rate is 30%.  Life expectancy is age 85.

The goal for Allen, who no longer has insurance is simple:  keep principal intact and live off interest.  The goal for Bob, who has a whole life insurance policy with a death benefit payable to his estate is a little more flexible:  spin down his remaining money by living off his principal and interest.

Who comes out ahead at age 85?

Read on..

When Allen and Bob pass away at age 85, Allen’s portfolio of $1,220,000 will still be intact, while Bob’s will bottom out at $111,313 (since he’s withdrawing the interest and principal each year).

However, what you need to know is Bob comes out ahead, well, at least his family does because of the tax-free death benefit payable to Bob’s estate.  This tax-free death benefit has grown from $491,914 at age 65 to $874,597 at age 85.  Upon his death Bob’s estate will receive $980,345 compared to Allen’s estate that will receive $925,700 after tax and probate fees.  So, in Bob’s case, he can spend freely during his retirement, enjoy his golden years and still be assured his estate will receive money as well.  Bob is able to spin his money down and use his whole life insurance policy as backup.

Now, you might be asking, that’s all fine and good if we don’t have another financial collapse.  What if we have another stock market crash like in 2008?  Well, Bob is even further ahead. You see, our friend Allen might have to take money from his principal to maintain cash flow.  For example, a 10% pull back on $1,220,000, will leave Allen with only $1,104,378.30 ($1,220,000 X 90% = $1,104,378.30). Allen will have to take money out of his nest egg and get even less money the following year. Meanwhile, Bob’s annual taxes decrease as he ages thanks to the whole life policy.  If Bob desires a guaranteed cash flow for life, at 65 in today’s market he could buy an annuity for life (never running out of money) and get 6.6% return (or even do it later at age 72) and get over 7% return guaranteed for life.  This can be done with some of the money to cover basic living expenses, while still leaving a large inheritance to the estate. You can read more about annuities here.

Here is a summary in a table:

Allen – Living off interest

Bob – Spending principal and interest

Insurance Coverage

None

Whole life policy

Investment Portfolio @ Age 65 – 5% ROR

$1,220,000

$788,000

Tax-Free Death Benefit @ Age 65

$0

$491,914

Investment Portfolio @ Age 85 – 5% ROR

$1,220,000

$111,313

Tax-Free Death Benefit @ Age 85

$0

$874,597

Total Net Worth

$1,220,000

$985,910

(less taxes)

$215,000

$0

(less probate, legal, accounting)

$79,300

$5,565

Total Payable to Estate

$925,700

$980,345

Does buying permanent life insurance coverage sound like the better choice now?

With whole life insurance not only do you have more money to spend in retirement, you also pay less taxes every year and are better protected. When you eventually pass away the death benefit will pass to your estate, avoiding capital gains and probate. As you can see, with the right whole life policy, even a retiree can come out ahead with less risk and you can spend their hard-earned money more freely.

This guest post was written by Brian Poncelet is an insurance specialist and independent certified financial planner (CFP) working in the financial services.

Filed in: Insurance

10 Responses to "Whole Life Insurance Part II: The Spending Game"

  1. Brian, can you explain why it’s just assumed Allen has a huge tax liability when he dies? Wouldn’t someone like you recommend that he be sitting on 95% cash/cash like assets as an 85 year old investor? Wouldn’t this mean the tax bill would be spread out over many years (because he’d slowly sell his investments) and not happen all at once?

  2. Murray says:

    Equations like these can customized to paint whatever picture is desired. The reader should remember that these people are motivated by their own best interests, not yours. Hmm, an insurance-selling CFP writing a review of insurance options, no conflict at all there.

  3. Hello Murray,

    The 5% returns at retirement is numbers Mark gave me to work with.

    Did you read part one? http://www.myownadvisor.ca/2012/09/you-think-term-always-beats-whole-life-insurance-think-again/

    If you have some other numbers please share them with us.

  4. Murray says:

    5% is an overgenerous assumption for insurance companies investing in low-yield bonds and Tbills, especially in the current environment. How about using the “guaranteed” rate that most policies quote, what is it, 2.5% now? Or did SunLife reduce it again. I suspect that most people reading this website want more control over their own investments, not less, and want lower commissions, not higher. On the “term life” side of the equation, an investor well-diversified into 40% fixed and 60% equity investments and who rebalances his portfolio yearly can easily beat 5% over a 30 year period…an “average” return for this risk profile is 9.6%.

  5. Hello Financial Uproar,

    Great question. “can you explain why it’s just assumed Allen has a huge tax liability when he dies?”

    You may recall (I’d re-read part I again http://www.myownadvisor.ca/2012/09/you-think-term-always-beats-whole-life-insurance-think-again/)

    Here is the math: Allen invests $1,000 per month for 20 Years)

    $1,000 X 240 = $240,000 we assumed he made an average of 7% which equals the $1,220,000

    How CRA looks at this is $1,220,000 – ($240,000 his money invested) = $980,000 which is capital gains.

    Out of the $980,000 gain the first 50% is tax free $980,000 X 50% = $490,000 assume for math he is at 445 tax bracket the money owed to CRA is $215,900.

    Go to CRA’s web site http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/rprtng-ncm/lns101-170/127/gns/clclt/menu-eng.html

    This explains the ACB etc.

    Remember the Government can and does changes the tax rules all the time.

    Capital gains tax in Canada was introduced in Canada in the year 1972 by the Federal government. Prior to 1972, one was not required to pay tax on capital gains in Canada. Capital gains tax in Canada was imposed with the aim of bringing about an equitable taxation system. Another reason for implementing the capital gains tax in Canada was to finance the social security system of Canada.

    See http://www.economywatch.com/tax/canada/capital-gains.html

    —————

    another idea is Bob spending down his money over a lifetime vs. Allen trying to live off his interest only.

    Brian

  6. Brian Poncelet, CFP says:

    Hello Murray,

    Great question. If you can get 9.6% every year with no negative years where you have to take money out the principle you will be ahead. The problem is I don’t think you can get 9.6% every year. Remember if you are in retirement you are pulling out not putting money in.

    Question what have you done over 10 years? How about this year….9.6% ?
    At 65 do you want to have 60% in stocks? What about 75 or since you are talking about 30 years at age 95 …60% in stocks?

  7. Matt says:

    We looked at one side of the coin how about the other. What if they both live to 90 years old. Bob would be screwed and Allan would be fine.

  8. Brian Poncelet, CFP says:

    Hello Matt,

    Your question or statement…

    We looked at one side of the coin how about the other. What if they both live to 90 years old. Bob would be screwed and Allan would be fine.

    Bob’s life insurance at that time would be worth $987,000 and the cash value is $844,000

    He can arrange to take what he needs out tax free. Allan has to pay tax.

    So Bob has more money to spend and leaves his family more. Also at age 90 my guess he would have sold his house he could spend some of the money on himself and leave his family with more money.

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