September 2nd, 2011 | Author: Mitch Reynolds

Life Insurance Can Create a Tax Deferred Insured Investment Plan for Children

Using life insurance to build a flexible, tax efficient investment plan for children

Have you ever thought about building an investment plan for children of yours? The Canadian government offers a great incentive for setting up a Registered Education Savings Plan (RESP) which we will discuss in the next article. A much less known investment plan for children is using Life Insurance to create a tax efficient long-term investment strategy that provides future cash flow and lifetime insurance protection for your kids.

How does life insurance on children work as an investment plan

The first thing we need to understand about this strategy is how permanent life insurance works in regards to taxation. The reason life insurance works as an investment plan for children is because of the tax sheltered growth of money inside a life insurance policy PLUS the no-tax transfer of the policy ownership. Let’s look at these two things separately.

Tax sheltered growth of money inside life insurance

One of the most efficient investment products in Canada today is a life insurance policy that allows tax sheltered growth. These permanent life insurance policies, often a universal life insurance policy, allow the owner to fund the plan over and above the pure cost of insurance risk protection. The excess dollars above the cost of pure insurance are invested into a portfolio of funds of your choice. Based on market returns, these funds can grow over time and create positive investment growth.

The investment portion of the universal life insurance policy falls under tax rules governing life insurance contracts. These rules allow the money inside the life insurance policy to grow and compound over time in a fully tax sheltered environment. When money is withdrawn from the policy during the life of the insured person (i.e. this is not a death claim), the growth portion of the money being withdrawn is taxed as income. If the money is left inside the policy to grow forever, the funds convert from a tax sheltered investment account into a non-taxable death benefit at the end of life.

Non-taxable transfer of a life insurance policy to a child

This is a very special tax rule in Canada allowing a “parent” (who can be a biological parent, grand-parent, adopted parent, step-parent, etc.) to buy a life insurance policy on a minor child and later transfer ownership of that policy to the child with no negative tax event to the parent.

So, it works like this: a parent buys life insurance on their child. They invest money into the policy over time. At some point in the future when the child is responsible enough and at least the age of majority (age 18) they transfer the policy to the child. All tax sheltered growth inside the universal life insurance policy is then transferred to the child and there is no deemed disposition of assets or tax on the investment gain attributed back to the parent. This creates an excellent intergeneration wealth transfer from parent to child. See the tax report below:

Manulife Tax Topic – Intergenerational Transfer of Life Insurance

Benefits of life insurance as an investment plan

The parent owns and control the investment portion of the life insurance until such time as THEY chose to hand over ownership to their children
Funds can be used for any reason – not limited to educational funding
If your child does not attend post-secondary school there is no negative consequences to investing in life insurance like there are with an RESP
Only the growth portion of money withdrawn from an universal life insurance policy is taxable as the initial investment was made with after-tax dollars
Money being withdrawn by children after the policy is transferred are taxed at the child’s marginal tax rate, which is usually much lower than the parent’s and can have many tax credits for continuing education
A life insurance policy will provide life-time protection for the child when they need it, like when buying a house, getting married or having children

Example of how a life insurance policy as an investment plan for children works

Here is an example of how a plan like this will create value for your child. We need to make a few assumptions for our case:

Universal life insurance policy bought for 1 year old child (boy) by their parents
They plan to invest $300 per month into the plan for 20 years
They also invest a lump sum $1,000 when they open the investment plan
The plan has an annual investment growth rate of 6%
They buy the minimum amount of life insurance needed to tax shelter their planned investment (in this case it is $382,000 of life insurance)
Total investment = $73,000
The child’s marginal tax rate when taking out money is 30%
At age 19, 20, 21 and 22 the child needs $10,000 after taxes to help fund school.
At age 28 the child gets married and takes out $15,000 after tax to help fund the wedding
At age 30 the child withdraws $30,000 after tax to put a down payment of his first home

Here is how this life insurance plan will work:

By age 18 this policy will have $92,700 in the tax sheltered policy fund
The child will have to take out about $11,500 per year in taxable dollars in order to have a net $10,000 in hand for education funding
For the wedding he will have to take out a lump-sum $18,400 to net $15,000 after taxes
For his down payment on the home he will have to withdraw $37,350 in order to net $30,000 after taxes
By age 31, the life insurance policy is still in force and has $46,261 in the tax sheltered policy fund.
If left alone from here on in, this policy will have $195,000 in the account by age 65 and $437,000 by age 80.
If he died at age 80, the total death benefit to his family would be $818,500.
Total investment = $73,000
Before tax withdrawals = $101,607 to net out $85,000 after taxes
Final estate value payout of $818,500

This is not bad for an initial investment of $300 per month for 20 years for your child. I will attach the Manulife universal life illustration below which shows the numbers quoted above.

Manulife Wealth Transfer Strategy Illustration

Manulife Wealth Transfer Brochure

Life Guard Insurance can help design a life insurance investment plan for children of yours

If getting a life insurance policy for your children’s future seems like a good investment, please feel free to contact Life Guard Insurance. We can help you design a life insurance investment plan that will meet your budget and help plan for your child’s future

The article was written by Mitch Reynolds+. If you found this article interesting or it made you think, please feel free to share your comments below. Liking us on Facebook, giving us a +1 on Google or Tweeting this article about life insurance as an investment plan for children would also be very much appreciated.