Universal Life Insurance generally has two components: an insurance component and an investment component. When a UL policy is “overfunded”, it means that money over and above what is needed to pay for the insurance premiums gets deposited to the investment component which is a tax-sheltered environment as long as you stay within certain limits (dictated by what is known as the MTAR line – “Maximum Tax Acturarial Reserve”).
The Tax Free Retirement Plan
A very popular financial planning strategy is called the leveraged deferred compensation strategy (also referred to as the “Insured Retirement Plan” and even “the tax-free retirement plan”) which involves overfunding a UL policy and letting the tax-sheltered investment grow over time, usually 10 years or more. Since you can’t take the money out without triggering capital gains, the strategy involves pledging the account as collateral for a loan from the bank (which you don’t make monthly payments on so the outstanding amount owing grows slowly over time). It eventually gets paid off when you die by the proceeds of the insurance policy and there should be money left over as well.
Since there is no tax paid to use these funds which were allowed to grow on a tax-sheltered basis you can see why it looks so appealing. This strategy is normally pitched to investors over 40 and who have maximized their RRSPs and have a significant amount of surplus cashflow.
TFSA Replaces This Strategy For Some
However, now that the Tax Free Savings Account (TFSA) is on the horizon this may put a dent into the smaller UL policies sold with this intention since the TFSA is tax-sheltered and better yet, the funds can be withdrawn without any tax being triggered. Better still is that you don’t have to fund the cost of permanent life insurance if you don’t really need it.
However, since TFSA contributions are limited to $5,000 per year if you are maximizing it from the get go, the LDCP will still be appealing to higher net worth investors who may want to use up more room than this.