In this blogpost I will discuss everything I know about life insurance policies and answer various questions associated with it.
Should I buy life insurance policy?
The purpose of life insurance policy is to pay out your liabilities, debts, funeral costs, and any other gifts that you may want to leave for your family after your passing. The way I see it, life insurance policy is a lottery ticket that you win only when you die. Since death is certain for everybody, life insurance is a lottery ticket that will certainly pay out. And the best part is that you get to choose the winning amount. The unfortunate part is that you won’t be around to enjoy the jackpot, only your family reaps the benefits.
In my opinion, everybody should buy a life insurance policy as early in their lifetime as possible. The younger you are when you buy the policy, the better. Why? Because the premiums will be lower. You will be able to pick a bigger winning amount for lower premium costs. Plus, if you buy an insurance policy in your twenties, you will most likely have the policy premiums paid off before you retire.
This is the tool all wealthy families use to pass on their wealth to the next generation. Parents buy participating whole life insurance policies for their kids as soon as they are born. By the time kids are in their twenties the policy premiums are paid off and they transfer the policy over to their kids, making them the policy owners. The parents use up all their savings during their retirement years. Now lets assume that the parents die at the age of 80, all their savings depleted during retirement years but their life insurance policy has been growing collecting dividends for the last 80 years. They transfer their death benefit, this big nest egg to the kids, tax free! But this is a topic that deserves discussion another day, under estate planning.
How much life insurance coverage should I buy?
This is dependent on your wishes. At a minimum your life insurance should be able to pay off all your debts and liabilities. Things like mortgage, funeral costs, taxes from sale of investments, car payments, etc. If you can afford it, you could buy insurance to replace your income for the coming years. For example, if you are expecting to make $1 million from now until you retire, you could buy insurance for $1 million to replace your income and help your family financially. Basically, sky is the limit here.
What are the different types of life insurance policies one can buy?
There are three main kinds:
1) Term life insurance: This is the cheapest form of life insurance one can buy. But the premiums do not stay constant. Premiums keep increasing with age and changes to your health. For example, you can buy a 20 year term where your life will be insured for the next 20 years for a fixed premium amount. But once the term is up and you decide that you still want life insurance for another few years, you will now end up paying higher premiums. Why? Because now you’re 20 years older. Or even worse, maybe you have diabetes now, which means no insurance company is going to even offer you life insurance. This is the kind of life insurance that most agents will want to push on you. Not because it is good for you but because it is good for the insurance company’s financial health. Because after your 20 year insurance term expires, if you’re still alive, you paid your premiums but the insurance company never had to pay out the death benefit.
2) Whole life insurance: This is the most relevant form of life insurance. If you’re buying life insurance, this is absolutely what you should buy. No matter what, one day, the company will have to pay out your death benefit. This is how these policies work. You pick a face amount/death benefit for your that will be paid out upon your death. Based on this face amount, your current age, and health condition, the company will determine a premium amount. You can choose to pay this premium amount over 10, 15, or 20 years depending on what the insurance company offers. You can also choose to pay the insurance premiums for life which typically means that you pay the premiums till the age of 100. You can buy two types of whole life insurance policies – a) Participating policies, where the company pays a dividend each year which can be used to buy more insurance also called paid up additions. So your death benefit and cash value keeps growing each year with the dividend payouts. The catch is that the dividend and cash values are not guaranteed and the dividend amount can change with changes in economic conditions. A participating policy is generally more expensive than a non-participating policy which brings me to, b) Non-participating policies, where the death benefit stays constant over time and the cash values are guaranteed. I personally prefer this option.
3) Universal life insurance: This is a more complicated form of life insurance. Here you have your life insurance component plus an investment component where you can park your money in your desired investment funds. This is a tool for people who have maxed out their RRSPs and TFSAs and want to invest their money under the life insurance act in a tax sheltered environment. This is probably not what an average Joe needs.
Since I personally own a whole life policy, I am going to talk more about it’s advantages and disadvantages.
1) You are covered for life and insurance premiums are fixed.
2)If you have a participating policy, you have the added benefit of participating in the insurance company’s fortunes as well as misfortunes.
3) You can pass on the death benefit to your family tax free.
4) The insurance policy comes with guaranteed cash values that you can borrow against, if need be. Or you can also cancel the policy and walk away with the cash value.
1) If you didn’t die young, you could have invested the insurance premiums yourself and turned it into a bigger amount than the death benefit.
Take myself for example
I bought life insurance at the age of 25. My total debt at the time was $200,000 so I bought a whole life policy from Desjardins Insurance for a face amount of $250,000 to cover my debt plus other costs and gifts. This was a non-participating policy so I received a table of guaranteed cash values from the company with the cash values for each year starting from age 25 to age 100. The insurance premium was roughly $44,000 which I decided to pay over 20 years. It came out to roughly $182 per month to be paid till the age of 45. Within a year of buying this policy, I got married and bought a house with my wife which increased my debt load to $500,000. I decided to buy another $250,000 of life insurance to cover my $500,000 debt. But this time I bought term life insurance. Why? Because I had the option to buy $250,000 of term life insurance for about $100 per year. This was really cheap and made sense to me because I figured that as I grow older, my debt load should decrease and I shouldn’t require $500,000 in death benefit for the rest of my life. The term insurance was a good and super cheap supplement to my life insurance needs plus it provided me with the flexibility to stop paying the premiums once its purpose was served.
How to use your life insurance while you live?
Most people think of life insurance as an investment that pays out only once you’re dead and serves no purpose while you’re alive. But this is not true. Your whole life insurance policy can act as a bank for your family. Do you need a loan for your daughter’s first car? Instead of loaning money from a bank, you can loan money against the cash value of your whole life insurance policy. A bank will only offer you a loan if you have good credit and are financially solid. No such checks are required to borrow against your whole life insurance policy. When times are rough and you really need to borrow some money, the chances are that the bank will reject your loan application anyway.
How about borrowing money against the policy to invest in a business? That’s even better because the interest you pay on the loan is now tax deductible.
Or maybe you reach the age of 85 and are still healthy. You have spent your RRSPs and TFSAs and are looking for another source of income. Well, your life insurance policy can do that for you. You can convert your whole life insurance policy into an annuity that pays you a fixed sum of money each year for the rest of your life. There is also the option to buy an Insured Retirement Program (IRP). An Insured Retirement Program allows you to use the whole life insurance policy as collateral for a line of credit. The IRP is appealing because it not only allows the policy owner to borrow money tax efficiently, but it also doesn’t require repayment of the outstanding loan and interest until the policy owner dies. As per the current law, some or all of the income received from an IRP can be received tax free.