Investing through life insurance can be tempting, but if you are not using your Tax-Free Savings Account (TFSA), it’s worth reconsidering. Before diving into why, let’s start with a brief introduction to TFSA, Whole Life Insurance, and Universal Life Insurance.
Tax-Free Savings Account (TFSA): A TFSA is a flexible savings and investment account available to Canadian residents that allows investments to grow tax-free. Contributions to a TFSA are not tax-deductible, but any income earned within the account, whether from interest, dividends, or capital gains, is completely tax-free. Additionally, funds can be withdrawn at any time without penalty, and the withdrawn amount can be re-contributed in the following year. The TFSA balance can be transferred to a named beneficiary after the death of account holder without incurring any taxes.
Whole Life Insurance: Whole life insurance provides lifelong coverage with fixed premiums, a guaranteed death benefit, and a cash value component that grows over time. Part of each premium funds the death benefit, while the rest contributes to the cash value. The cash value accumulates tax-deferred and can be borrowed against or withdrawn, though unpaid loans reduce the death benefit. While it offers benefits like lifelong coverage and cash value, whole life insurance is more expensive than term insurance
Universal Life Insurance: Universal life insurance is a flexible, permanent insurance that combines a death benefit with a tax-deferred investment component. Policyholders can adjust their premiums and death benefits, subject to certain limits. The cash value in a universal life policy grows based on the performance of the investments chosen by the policyholder. It also grows tax-deferred, but fees and charges can be higher compared to other investment options. It is very complex and requires active management.
Benefits of a TFSA
- Tax-Free Growth: One of the biggest advantages of a TFSA is that any interest, dividends, or capital gains earned within the account are completely tax-free. This allows your investments to grow more efficiently over time.
- Flexibility of Contributions: Unlike life insurance premiums that require consistent payments to maintain coverage, TFSA contributions are entirely flexible. You can pause, skip, or adjust contributions based on your financial situation.
- Flexibility of Withdrawals: Funds in a TFSA can be withdrawn at any time without penalties. Plus, the amount you withdraw can be re-contributed in the following year, making it a highly flexible savings vehicle.
- Estate Planning Advantage: A named beneficiary can inherit the TFSA without any taxes, simplifying the transfer of assets after death.
Considerations for Life Insurance as a Savings or Investment
- Higher Costs: Life insurance policies with an investment component, such as whole life or universal life insurance, often come with higher premiums and fees compared to traditional investment accounts.
- Complexity: These policies can be complicated, with various fees, charges, and terms that may not be fully transparent. Understanding what you’re paying for and how the policy works can be challenging.
- Liquidity Issues: Accessing the cash value in a life insurance policy can be more complicated than withdrawing from a TFSA. There may be surrender charges, Interest charges and accessing the funds could have tax implications.
- Age/Gender Restrictions: Age and gender can impact eligibility and cost, making them less affordable for some individuals.
When to Consider Life Insurance for Savings or Investment
- Estate Planning: If you have complex estate needs, a permanent life insurance policy can be a valuable tool.
- High Income earner: High-income earners who have already maximized their contributions to other tax-advantaged accounts such as TFSA and/or RRSP may find life insurance beneficial for sheltering additional savings.
Below is a comparison of a 35-year-old male investing $100 per month for 20 years in each option.
Whole Life: DSIR 6.40%
Universal Life: 8%
TFSA: 8%
illustration purposes only
The cash value accumulation of whole life and universal life insurance policies cannot compare to the performance of a Tax-Free Savings Account (TFSA). Unlike life insurance, a TFSA is not burdened by the high costs and fees typically associated with such policies. Over time, the TFSA’s value will even surpass the death benefit provided by life insurance
Key Takeaway
Maximizing your TFSA should be your first priority when your main goal is growing wealth, due to its tax-free growth, flexibility, and simplicity. Once you’ve fully utilized your TFSA, should you consider life insurance as a savings or investment vehicle. If anyone suggests otherwise, it’s wise to seek a second opinion before committing your hard-earned money. Be sure that any decision aligns with your financial goals and overall situation.