Question. My spouse and I have recently purchased a house, and are planning to have a baby next year. I have some life insurance through my group plan at work, but my spouse is self-employed as an independent contractor, and has no employer benefits. We have a fairly big mortgage on our house, and we are thinking about purchasing life insurance, but aren’t sure what type of policy we should get. Can you tell us what type of policy is best for us?
Answer. It’s great that you’ve recognized the importance of protecting your family. Specifically, since you currently have a mortgage, and are planning to have a baby, there would be significant financial hardship for the surviving spouse and the child in the event of an untimely death of either of you.
This is a very substantial risk – you could jeopardize losing the house if the surviving spouse can’t afford the mortgage payments. Further, you could also derail plans to help contribute towards your child’s education, sports, and other activities, further disadvantaging the child. The good news is that life insurance is the perfect tool to help protect against this financial risk, by providing funds exactly when they are needed most. Perhaps one of the most attractive features of life insurance is that the death benefit is paid tax-free to the beneficiary. This is true of every type of life insurance in Canada – term, permanent, group, or individual.
So, what type of policy should you buy? When purchasing life insurance, one of the biggest considerations is the type of policy.
Let’s take a look at the types of insurance available, term and permanent, and the key features of each.
Unlike certain types of permanent insurance, term insurance has no cash value, and only provides a death benefit. Therefore, if you’re still alive at the end of the term, the policy will simply expire with no value.
Key features of term insurance include:
- Most affordable type of insurance;
- Easy to understand;
- Provides coverage for a specific length of time (term), such as 10 or 20 years;
- Term can be extended / re-purchased if you wish to continue after the initial period;
- Rates increase considerably with age;
- Age limit – most companies no longer offer term insurance past age 60 or 70;
- Can typically be converted into a permanent policy.
There are three main types of permanent insurance – whole life, universal life (UL), and term-to-100 (T100). Although T100 has the word “term” in its name, it is a permanent life insurance product. Like term policies, T100 also has no cash value, whereas whole life and universal life policies both allow for investment within the policies, thereby creating cash values.
Key features of permanent insurance include:
- Provides protection for your entire life – never expires;
- Potential to secure a guaranteed level premium for life;
- Whole life and UL policies accumulate cash value – this presents opportunities for additional tax-sheltered investment growth and future borrowing;
- Premiums are typically much higher than term insurance in early years;
- T100 is easy to understand, but UL and whole life policies can be very complex.
How to Decide – Which Policy is Best for You?
While there is no universal “best” type of insurance for everyone, your own unique personal circumstances will typically dictate which type of policy is best for you.
When choosing between permanent or term life insurance, consider the following:
- You current health and age;
- The risk you are protecting against;
- The financial needs of your family;
- Outstanding mortgage and other debts;
- Estate planning needs;
- Funeral and final expenses;
- Children and related needs such as education;
- Your family and your retirement.
With these items in mind, let’s consider two different scenarios with different life insurance solutions.
A young couple with a mortgage and a 5-year old child need to protect their family. They want to make sure that if either spouse dies, the other can continue to live in the family home and raise the child properly, and cover the cost of the child’s postsecondary education. In this case, the most suitable product is likely a Term 20 (T20) life insurance policy. First, because the key risks – mortgage and child’s education and other expenses – simply won’t exist in about 20 years. By then, the mortgage will be paid, and the child will be finished school. And the other reason for selecting term, is cost. Young families often have many competing demands on cash flow, and keeping costs down is therefore a top priority. In fact, for many, the only way they can afford the amount of coverage they need is by purchasing term life insurance, as permanent is simply too expensive.
A couple approaching retirement wants to leave an inheritance to their adult children. They have some money in their RRSPs that they do not expect to spend, and intend to leave it as an inheritance to their children when they pass. However, as we know, every dollar withdrawn from an RRSP is fully taxable at the investor’s marginal tax rate (MTR). This is the main problem with using the RRSP to structure an inheritance – after taxes, the actual amount inherited is closer to half of the RRSP value. Therefore, structuring the inheritance with a life insurance policy is a much better strategy. However, what makes this a suitable application for permanent life insurance in particular, rather than a term plan, is the nature of the client’s needs. This is not a situation where they need to protect against a specific risk for a specific period of time. Rather, in this case, the couple wants to ensure that there is an insurance policy in place when they die – whenever that may be – so they can ensure they leave a meaningful inheritance to their children. Since term policies eventually expire, the only way to achieve this goal is with a permanent policy, as it will never expire (provided the premiums are paid).
As we’ve seen, one of the most important things to keep in mind, when evaluating insurance policies, is to match the insurance with liability. While term life is generally much cheaper in the initial years, a permanent policy lasts throughout your entire lifetime.
Of course, the other key consideration when buying insurance, other than the type of policy, is the amount – how much is enough? Stay tuned for a future post as we discuss how to determine the appropriate amount of insurance to meet your needs.
Interested in learning more? Contact your advisor.