Cashing in Your Life Insurance Part 1

Thinking of cashing in your old life insurance policy? Before you do, make sure you truly understand all of the consequences and take a look at the alternative options available to you.

There are many Canadians who have a permanent life insurance policy (commonly called “Universal Life” or “Whole Life”) that has been in force for many years. A lot of these policies were setup by their parents a long time ago and largely forgotten about over time. Policy-owners today are looking at their statements and seeing substantial cash surrender values on them and thinking this money would go a long way to paying off some bills or funding the purchase of a new car or a big trip.

Cashing your policy in and surrendering your coverage is a decision that should not be taken lightly though and I’ll start by telling you why.

The first thing to consider is the tax situation that will occur. A permanent policy will have an adjusted cost base (ACB) which is made up of the premiums put into the policy less the net cost of pure insurance. For example, let’s say your policy has an ACB of $15,000 and a cash surrender value (CSV) of $75,000. By cashing the policy out, you would have to pay taxes on the $60,000 of excess value over the ACB. If you’re working full time, this extra taxable amount could mean a lot of the policy’s value would head to the government instead of your hands.

Second, you should consider your estate planning and if the insurance should be kept in force to fund or enact those plans. The life insurance may provide immediate liquidity for your executors or loved ones to pay for final expenses. More importantly, if you plan to leave money behind to your children, the life insurance policy might provide a much larger benefit amount over other investment assets.
Let’s say a 70 year old has a $100,000 life insurance policy that is costing them $50/month in premiums and has a $20,000 CSV. They might like the idea of having $20,000 of cash in their hands and also not paying out $50/month anymore now that they’re retired. Seems like a “win win” right?

What if this same 70 year old retiree has a pretty good pension and more money saved up then they will likely spend in their retirement years? Let’s say that their retirement and estate plans are calling for a good chunk of money to be left behind for their two kids anyways.

If they cash the life policy in and pay $5,000 in taxes, they are left with $15,000 net. If they were to invest the $15,000 in a TFSA (so no taxes will be owed on the growth) and invest the $50/month they’re saving in premiums here as well, they would have $50,000 at age 85 or $71,000 if they live to age 90 based on a 6% rate of return. .

Either way, the kids are left with less money than if the retiree had simply left the policy in force – in which case the kids would’ve received the full $100,000 amount, completely tax free. They would need to live to at least age 95 before the kids receive the same amount of money; an age that is much higher than the statistical average. On the flip side, if the retiree passes away at 75, the kids would only receive $23,600 from the policy’s value.

Turning this around and looking at it from a investment rate of return point of view, if we assume the retiree passes away at age 80 (typical mortality rates in Canada), the cashed out policy money in the TFSA would have to earn an annual rate of return in the 19% range to break even. If I offered you a guaranteed investment paying out 19% per year, pretty sure you’d snap it up in a heartbeat!

So before you decide to cash in that old life insurance policy, make sure you consider all the ramifications of doing so. Stay tuned for next week’s article where I’ll discuss some alternative options to cashing out a policy if you do need to access some of the cash values it holds.