Accessing the Cash Values in Your Life Insurance Policy: A Guide to Liquidity Options

Permanent life insurance, particularly policies with a cash surrender value (CSV), can be viewed as a valuable component of a client's financial strategy, offering not only long-term protection but also the potential to preserve and improve liquidity. The inherent structure of these policies, particularly those with a cash value component, allows for the accumulation of funds on a tax-deferred basis. This tax deferral means that the cash value can grow without the immediate erosion of taxes, allowing for a larger pool of readily available capital in the future. Unlike taxable investments, where growth is subject to annual taxation, the inside buildup within a permanent life insurance policy enhances the potential for liquidity by maximizing asset accumulation.

Furthermore, permanent life insurance policies provide multiple avenues for accessing the cash surrender value (CSV) during the policyholder's lifetime, offering financial flexibility to address various needs or opportunities. These access methods, however, have distinct tax implications that financial advisors must understand to guide their clients effectively. The three primary methods are cash withdrawal or partial surrender, policy loans, and collateral loans.

#1 Cash withdrawals/partial surrender:

The first method, cash withdrawal or partial surrender, involves directly taking funds from the policy. For tax purposes, this is considered a taxable disposition of an interest in the policy. A taxable policy gain arises if the cash withdrawn exceeds the prorated adjusted cost basis (ACB) attributed to the withdrawal. The ACB increases with premiums paid and decreases annually by the net cost of pure insurance (NCPI). While offering ease of access and no obligation for repayment, withdrawals are final (and not repayable), reduce the policy's cash value and future growth, and can decrease the death benefit.

#2 Policy loans:

The second method is a policy loan, where funds are borrowed directly from the insurance company using the policy's cash value as security. Policy loans up to the policy's ACB are received tax-free. However, a taxable policy gain can occur if the loan exceeds the ACB. Interest paid on policy loans is usually added to the ACB unless it is tax-deductible, which may be the case if the loan proceeds are used for income-earning purposes from a business or property and properly documented. Some of the advantages of the policy loan method are ease of access with limited administrative requirements and no financial underwriting. The cash value remains intact (though encumbered), potentially preserving the policy's growth potential compared to a “withdrawal. The downside is that they typically have higher interest rates than bank loans, and outstanding loans reduce the death benefits. For corporate-owned policies, an outstanding policy loan at the time of death can reduce the capital dividend account (CDA) credit.

#3 Collateral Loans:

The third method involves a collateral loan, where the life insurance policy is assigned to a third-party financial institution as security for a loan or line of credit. Loan proceeds from a collateral loan are typically received tax-free. Interest paid on the collateral loan may be tax-deductible if the borrowed funds are used to earn income from a business or property, meeting the CRA's "purpose test". This method is often considered the most tax-effective way of accessing cash values. However, collateral loans involve administrative requirements, potential fees, and are full recourse loans with interest charges, and the lender can demand repayment. For corporate policies, and unlike the “policy loan” method, the outstanding loan at death does not reduce the CDA credit?

Like in the “policy loan” method, there’s a potential for interest deductibility when CRA’s purpose test is met, as well, when dividends are paid based on the CRA’s “fill the hole” requirements. In “shareholder/personal borrowing” scenarios, one needs to address the potential for a taxable shareholder benefit if the corporation's policy secures a personal loan. Payment of a guarantee fee while alive and undergoing an estate assets swap on death can potentially resolve this issue.

As a financial advisor, it is crucial to have a comprehensive discussion with your clients before they access their policy's CSV. To guide them effectively, consider asking the following questions:

What is the primary reason you are considering accessing the cash value at this time?

For what are the specific funds intended to be used?

Have you explored other potential sources of funding?

What is your comfort level with potentially reducing the future growth of the policy?

Are you aware that accessing the cash value can directly or indirectly reduce the death benefit?

Have you consulted with your legal and tax advisors to understand the full implications?

Are you comfortable with the potential tax implications for each access method considered?

Do you understand the impact on the policy's ACB?

Are you aware of the interest rates and repayment obligations associated with loans?

By addressing these questions, you can help your clients make informed decisions that align with their overall financial goals.