Term vs. Permanent Life Insurance

Term vs. Permanent Life Insurance

In this article I want to discuss a question I get a lot, the difference between term life insurance and permanent life insurance.  I’m going to speak to the major differences and how families and business owners incorporate both into their financial plans. 

But first, what is life insurance? 

A life insurance policy is a contract with an insurance company.  In exchange for regular payments, the insurance company provides a lump-sum amount of money (death benefit) to the person or organization of your choice.

Life insurance company’s use health, lifestyle and family history questions to determine your premium payment.  At its very essence, life insurance premium is determined by your life expectancy. 

Term Life Insurance

Term life insurance provides protection against financial loss during a specified period of time.  You can think of term life insurance like renting a home.  When you rent a home, you pay rent over a specified period of time outlined in your lease.  When your lease is up, you renew your contract. 

There are many different ‘terms’ to choose from when it comes to a term life insurance policy.  The most common policies are term-10, term-20, term-30, term-65 (lasts until age 65), term-life (lasts until you die).  The longer the term, the more expensive the premium.  However, the younger you start, the less expensive the premium.

As an example: $1,000,000 of 10-year term life insurance on a 35-year old male is $42 / month.  The insured will pay $42 / month and if he dies within the 10-year period, his beneficiary will receive $1,000,000 tax-free.  Once the 10-year period is up, if there is still a need for insurance, he will have to renew his insurance at a higher cost (due to age).

Term life insurance is the most efficient way for families to cover financial loss due to an unexpected death. 

Families often consider the following when determining how much term life insurance they need:

  • Debt:  The surviving spouse typically wants the mortgage on the house to be paid off
  • Income replacement:  How much income the surviving spouse and children need to maintain a lifestyle they are used to living
  • Children’s education:  Enough money to cover children’s university/college experience

A classic example to think about is a family with a stay at home spouse, 2 children and a mortgage.  What if the breadwinner in the family passes away with no life insurance?  How would the surviving spouse, who has no job, support the children and pay a mortgage?

Business owners also use term life insurance in several ways:

  • Key man insurance:  A life insurance policy on anyone who is crucial to the operation of the business – typically the owners.  The purpose is to ensure the business does not sink if a key employee/owner passes away unexpectedly.
  • Fund buy-sell agreements:  A life insurance policy purchased by the business on each business owner so that in the event of a death, the business has enough liquidity to buyback the shares from the deceased’s beneficiaries.  This is important because often the beneficiaries of the shares are not involved and want no involvement in the business.  Term life insurance can be used if the business has an end date in mind.

Permanent life insurance

Permanent life insurance is life insurance that stays in force until you pass way.  You can think of permanent life insurance like owning a home, it’s an asset.  The premium you are paying each year for the insurance policy is like paying your mortgage, you are building equity or ‘cash value’ inside of your policy. Permanent life insurance is far more expensive than term life insurance.

One key characteristic of permanent life insurance is a feature known as cash value.  Cash value grows inside of the policy on a tax-deferred basis (like an RRSP) and can be used in the future.  Cash value can either been withdrawn from a policy and will be taxed as income or borrowed from the policy tax-free.  Any outstanding loan from the policy at death will be paid back using the death benefit of the policy.  If the cash value is never touched, any growth will payout tax-free at death to your beneficiaries.

There are two types of permanent life insurance, universal life and whole life.  Guaranteed universal life insurance is very vanilla – you have a premium and death benefit that never changes.  You can deposit additional money beyond your premium inside of a universal life policy that can be invested in various investment vehicles, growing your money on a tax-deferred basis.  If the money is never withdrawn, it will pay out tax-free to your beneficiaries as part of the death benefit.

Whole life insurance is insurance with a forced savings aspect.  It is more expensive than universal life because part of the premium is added to an invested savings component (cash value).  Each year the insurance company pays a dividend that can be used to purchase additional insurance (paid up additions).  Once again, if the cash value is never touched, the death benefit and additional paid up additions are paid tax-free to your beneficiaries.

Families often use permanent life insurance for the following reasons:

  • Liquidity to pay estate taxes:  Children are typically the beneficiaries of their parents’ estate.  Permanent life insurance provides liquidity to cover taxes the estate must pay.  A common example is a family who owns several real estate properties.  At death, the government assumes a ‘deemed disposition’ of said properties.  Any growth on the properties will be taxed even though the properties have not been sold.  If the goal is to keep the properties in the family, life insurance provides liquidity to cover the tax.
  • Inheritance / estate equalization:  Simply put, permanent life insurance is a great way to leave an inheritance to children.  It is also the best way to equalize an estate to ensure assets are divided equally among beneficiaries.  A common example is when one child works in the family business and another does not.  Life insurance provides compensation to the child who is not involved in the business to make sure the estate is equal.
  • Charitable gift:  Permanent life insurance is a wonderful way to leave an impactful gift to a charity you support.  It is far more efficient than leaving a cash gift as your gift can be magnified for far less money.  For an example of this check the link: charitable gift
  • Alternative to grow money on a tax-free/deferred basis:  Permanent life insurance can act as a tax shelter, like a TFSA or RRSP through the cash value inside of the policy.  If the cash value is never touched, any growth will pay out tax-free to beneficiaries at death.  At times, individuals will withdraw portions of their cash value during periods when they are in a lower marginal tax bracket – such as retirement.  Cash value from a permanent life insurance policy can also be borrowed tax-free.  Any outstanding loan amount at death will be subtracted from the policy death benefit.

Business owners often use permanent life insurance in the following ways:

  • Money out of corporation tax-free:  Business owners who have excess cash in their corporations may be reluctant to withdraw the funds as heavy income tax will be incurred.  If the cash is not needed the business owner could fund a life insurance policy using their corporate dollars.  When the business owner passes away, the insurance proceeds get paid into the corporation tax-free and create a credit to the capital dividend account.  This credit can be paid out to the shareholders as a tax-free capital dividend.  
  • Fund buy-sell agreements for succession planning:  Unlike a business with an end date, a family business that lasts for generations may use permanent life insurance to fund the stipulations set out in the shareholder agreement.

I hope this guide has provided insight on the main differences between term and permanent life insurance.  One is not better than the other, it all depends on what you are trying to achieve with your financial plan.

For additional questions please visit www.insuranceanswered.ca/life or reach out to me at david@stewartfinancial.ca.

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Plitvice National Park is a must see when travelling through Croatia, the waterfalls are breathtaking. We stopped in after we visited Dubrovnik and Hvar, as it was on our way up to Zagreb. From there we ventured to Budapest to continue our travels.

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