TikToks about using your life insurance tax-free while you’re alive
Marie-Helene Lanoix-Verreault - Jan 09, 2023
In the past year, I received a few shares through my private messages from clients about “TikTok videos talking about tax-free, cash-back insurance. First off, I’ve reviewed these videos and I’m not 100% sure they’re only Canadian. U.S. rules and taxation are very different and don’t apply to Canadian insurance policies. I’ll focus on my understanding of Canadian rules in this blog…
The claim by these TikTokers that life insurance is “cash back insurance that grows tax-free” is misleading. It doesn’t apply to all types of life insurance. They’re referring to a type of insurance called participating life insurance. With this type of policy, over time, it builds cash value. You have guaranteed access to these funds, assuming you make required payments and the policy remains in-force. Withdrawing funds may result in taxable income being reported to you.
Let me explain a little how it works... Over time, your participating life insurance policy builds cash value. You have guaranteed access to these funds, which you can use while you’re alive to cover emergency needs or fund a child’s education, to list two examples.
When you buy participating life insurance, you share in the experience of the participating account with everyone else who owns a participating policy. Each year, you may receive what’s called a policyowner dividend. Dividends aren’t guaranteed, but once they’re credited to your policy, they’re yours. With these dividends, you can:
- Buy additional insurance coverage (which may increase your cash value)
- Reduce (or even stop) out-of-pocket premium payments
- Take your dividends as cash
While TikTokers talk about a policy’s cash value as if it were just a tax-free investment, remember, it’s a life insurance policy first – it’s not a tax-free savings account and you should be careful not to confuse the two.
4 ways to access your policy’s cash value
1 – Cancel some, or all, of your policy. You might cancel some or all of your coverage in exchange for cash value associated with the cancelled coverage, adjusted for any loans or fees. You might be taxed if you receive cash in place of your cancelled coverage.
2 – Policy loan. This is the simplest method. You can borrow money, with interest, from your insurance company against your policy’s cash value. If you don’t pay it back, it’ll come out of your payout. Funds that are withdrawn or borrowed from your policy may result in taxable income being reported to you. In addition, any withdrawals or unpaid loans will decrease the size of your insurance payout, or in the case of a policy loan, if the loan plus interest exceeds the policy’s cash value, the policy will end.
3 – Use your policy as collateral for a loan or line of credit. Banks and other third-party lenders may lend against the policy’s cash value. This is known as a collateral loan. The loan is tax-free, but you pay interest to the lender. Like a policy loan, a collateral loan doesn’t reduce your insurance coverage, or affect the cash value growth or any dividends the policy may receive. If the loan isn’t repaid, the balance, including interest, is deducted from the amount paid out at death. Depending on the lender, a collateral loan might give you a lower interest rate This method should only be considered by sophisticated investors with high risk tolerance. Before you consider using your permanent life insurance policy as collateral for a line of credit, obtain advice from your financial security advisor, lawyer or accountant.
4 – Death benefit. That is 100% tax free to a named beneficiary. Your basic life insurance, and whatever value of death benefit associated with dividends, if any, will be paid tax-free to your beneficiaries at your death.
This may result in taxable income being reported to you.
This “tax-free investment life insurance strategy shared by TikTokers sounds quite attractive, but it’s not as simple as they may make it seem. Remember your insurance costs first. Finally, before considering such a strategy, which is certainly suited to some individuals, I strongly believe you should first handle the basics of financial planning, such as having an emergency fund, a tax-free savings account, a registered retirement savings plan and having paid your debts, or at least most of them and speaking to your advisor.
Marie-Helene Lanoix-Verreault, CFP®
Certified Financial Planner at Sigouin Financial Group Inc.