At first glance, life insurance and RRSPs seem very different. One provides a tax-free death benefit, while the other provides taxable retirement income. However, permanent life insurance in Canada is bundled with an investment element, that can serve a similar purpose to RRSPs.
But which is better, RRSPs or permanent life insurance? To find out, let’s compare and contrast the two. Below is everything you need to know about life insurance vs. RRSPs.
A few definitions
But first, lets get everyone on the same page. Here are the absolute basics.
How do RRSPS work?
RRSP stands for registered retirement savings plan. These are government-approved, registered accounts that make it easier to save for retirement. Contributions to RRSPs can be used as tax deductions, reducing the amount of tax you’ll pay each year (up to annual limits). As long as the money invested remains in the RRSP, all capital gains and dividends are tax deferred.
How does permanent life insurance work?
Permanent life insurance is life insurance that lasts your entire life. As long as you pay your premiums, your beneficiary will be paid a benefit when you die. Permanent life insurance also comes with an investment element, which accrues value as you invest over and above your regular premiums. The exact way this investment account works differs between different types of permanent life insurance, but they are both similar to investing in RRSPs.
To be clear, we’re only talking about permanent life insurance in this article, as term life insurance doesn’t offer tax-sheltered savings.
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Similarities between RRSPs and life insurance
RRSPs share several similarities, though most of these similarities are restricted to the investment portion of a permanent life insurance policy. The main similarity is that both offer tax-sheltered (or tax-defferred) growth.
What is tax-defferal?
Tax defferal refers to when your investments are taxed by the government. In a normal savings account, you’ll pay tax on your income, then deposit your after-tax cash into the account. You’ll also be required to pay tax on any earnings from that account (interest or dividends for example).
A tax-deffered savings account lets you claim any investments on your tax return, reducing your taxable income. The money in an RRSP or permanent life insurance account will be taxed on withdrawal, typically during retirement. Any returns on your investments in an RRSP or permanent life insurance account will also only be taxed on withdrawal.
This arrangement gives you more funds to invest with today, that you would otherwise have had to pay in tax. Those funds can then grow at a faster rate than normal rate. When you do finally withdraw the funds, you may be payin a lower tax rate than you are today. In this case, you’ll be making another saving on top of the accelerated growth.
Not that the tax-deffered potential of both permanent life insurance and RRSPs are subject to annual limits.
Who benefits most from tax-deffered growth?
Anyone paying tax on their earnings can benefit from tax-deffered growth, provided they give their investments time to grow long term. However, you will get more from tax-defferal if you are earning more money, and paying a higher amount of tax each year.
For example, assume Person A earns $200,000 a year, and invests $10,000 in an RRSP. Their highest tax rate will be high – let’s say 50%. Their $10,000 reduces their taxable income to $190,000, which results in a saving of $5,000.
If Person B earns just $45,000 a year, their highest tax rate will be around 15%. Say they were able to invest $10,000 in their RRSP – they would reduce their taxable income to $35,000. This would result in a tax saving of just $1,500.
Over time, this difference would compound to an even higher amount. Despite the equity issue here, the individual takeaway is that it’s a good idea to use any tax-deffered saving offering that you’re able to, in order to maximize your savings for retirement. Because RRSPs and permanent life insurance have separate annual limits, it’s often a good idea to have both. If you can max out your RRSP contributions, permanent life insurance gives you the opportunity to create even more tax-deffered value.
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Differences between RRSPs and life insurance
When comparing RRSPs and life insurance, they are more different than they are similar. The actual life insurance portion of a permanent life insurance policy makes it a fundamentally different product than an RRSP. These are the key differences:
Taxable withdrawals: With an RRSP, you’re forced to make taxable withdrawals whether you want to or not. An RRSP takes decades to grow to a large amount. That also leads to a big tax bill at death. With life insurance, you’re not required to make withdrawals and the death benefit itself is generally tax free. Also, the death benefit is generally very large, relative to the premiums.
Annual contribution limits: RRSPs have the same fixed contribution limits for everyone. For 2020, the maximum RRSP contribution is $27,230 (though it also cannot be more than 18% of your previous year’s income). With life insurance, the maximum deposits depend on your age, health, and the face amount of the policy (the amount of money paid out when the person dies).
Changes in value: An RRSP’s value increases over the years as you make more contributions and your investments grow. This is the same as the investment component in a permanent life insurance policy. However, the death benefit of a life insurance policy is worth more today, since the death benefit is much larger than the premiums. As you live longer, the return on investment drops. That’s a trade-off you’re likely willing to make.
Creditor protection: Life insurance is generally protected from creditors. However, RRSPs are generally subject to claims by creditors in Ontario unless purchased from a life insurance company.
The bottom line
Why not get both? If you’ve reached your RRSP and TFSA contribution limits, permanent life insurance lets you save more. Life insurance can also supplement an RRSP during the accumulation phase, as the death benefit covers you if you were to die before you could save enough. If you want to provide retirement income for your partner, you could use term life insurance.
If your partner will need to depend on your RRSP for retirement income, your death harms them. Life insurance provides a tax-free lump sum to replace the contributions you couldn’t make while term life insurance is a cost-effective solution. During retirement, life insurance can prefund the taxes at death on RRSPs and other taxable investments. In this case, you’ll want permanent coverage.