When we think of life insurance, we think of a financial product that helps protect our families in the event the worst happens. Some individuals also see life insurance as a way of funding final expenses and estate taxes. However, the versatility of life insurance, especially permanent insurance, can create other benefits.
The more I sit down with new parents, the more I hear about their desire to create a legacy for their children and beyond. Life insurance can certainly be used in this case, but not in the way that you might be thinking.
The concept is simple. A parent takes out a participating whole life insurance policy on the life of their young child. The participating whole life insurance policy is one that has the potential of generating cash value over time, which can serve to increase the death benefit. When the child is an adult, she can become the owner of the policy. She could then choose to surrender the
policy to access the cash value to buy her first home, fund post-graduate studies, start a business, or any multitude of possibilities. Of course, there are some tax implications and you should discuss your specific legal/tax situation with the appropriate legal/tax professional.
However, if the child decides not to surrender the policy and lets it grow, she can one day make her child the beneficiary, creating a significant intergenerational transfer of wealth.
Assuming all premiums are paid when due, the total cash value in the participating whole life policy is comprised of two components:
- The basic cash value guaranteed by the insurance company
- Non-guaranteed values generated by dividends.
You might be wondering what dividends are. Participating whole life policyowners get to participate in the potential returns, or dividends, of a participating investment account, which is maintained by the insurer for its participating policies. These dividends are not guaranteed and can vary up or down from year to year.
Now, let’s consider the following example:
John, a physician, has a young daughter, Lisa, who is 2 years old. John is already saving for Lisa’s post-secondary education using the Registered Education Savings Plan (RESP). But he wants to do more. After receiving some professional advice, he decides to start a whole life insurance policy on Lisa’s life. John owns the policy and is the beneficiary for now, his daughter Lisa is the insured. The premium in this particular example is approximately $2600 a year for the next 20 years. The initial death benefit amount of the policy is $250,000.
Twenty years later Lisa is 22 years old and the policy has been paid up. That means that John does not need to fund this policy anymore. Remember, dividends are not guaranteed, and can change from year to year. However, for the purposes of this example only, let’s assume that all assumptions made to generate the values in this example, including but not limited to dividends, hold. In our example, the cash value of Lisa’s policy would now be approximately $50,000, and the death benefit would now be approximately $420,000 and would continue growing. When Lisa is 28, John decides to transfer ownership of the policy to Lisa. This can be done without triggering any tax since Lisa is John’s daughter. At this point in time, the cash value of the policy is approximately $86,000 and the death benefit amount has grown to approximately $526,000.
Lisa decides to leave the policy in force so that it can continue to grow. Eventually, Lisa has a child of her own, Jake. She changes the beneficiary of the policy to Jake, John’s grandson. Eventually John passes away but this does not affect the policy. Eventually, Lisa passes away at the age of 89, leaving Jake with the death benefit of the insurance policy that her father started. Jake receives approximately $2.2 million tax free.
What has happened here? John took out a policy on his 2 year old daughter that eventually grew to a sizeable inheritance for his grandson. John has left a legacy across 3 generations in a tax efficient and cost efficient manner. Both John and Lisa could have used the policy in many different ways in their lifetime, this is just one example.
Life insurance is usually thought of as a financial safety net to protect our family in the event of untimely death. Individuals with young children will often take out a life insurance policy on themselves because they see the importance of doing so. However, insurance can be used in so many other ways, including creating a legacy for your future generations to remember you by.*
* The information provided in this article is for information purposes only. This article should not be construed as insurance, investment or financial advice, or as an offer or solicitation to buy any products or services mentioned herein. No one should act upon the examples/information without a thorough examination of their specific legal/tax situation with the appropriate professional advisors.