Surrender, Loan, or Reduced Paid-Up
Robert, 58, owns 100% of a hardware store. In 2009 he bought a $500,000 participating whole life policy on himself. Today it has a cash surrender value of $94,000, an adjusted cost basis of $41,000, an outstanding policy loan of $30,000 at 6% (interest capitalized), and an annual premium of $9,600. The policy is collaterally assigned to his bank to secure a $250,000 operating loan for the store. The corporation holds $150,000 of group life, which ends when Robert retires or sells the business. Robert also has a $300,000 mortgage, a wife, and two children in university.
Robert has just learned that his RRSP contribution deadline is in three weeks and wants to surrender the policy to fund a $60,000 RRSP contribution and pay $40,000 against the business line of credit. He says: "The cash value is dead money and the premium is killing me."
1. What is the effect of the collateral assignment, and what can Robert not do without the bank's involvement?
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A collateral assignment gives the bank a limited, secured interest in the policy: it can receive proceeds only up to the amount outstanding on the operating loan, with any excess going to the named beneficiary. It does not transfer ownership, it does not make the bank the beneficiary, and it does not give the bank the right to change the policy.
What it does do is require the bank's consent before any transaction that reduces the bank's security. Surrender, a large policy loan, or a change to reduced paid-up status all shrink the asset the bank is relying on, so the policyholder cannot complete them unilaterally. In practice the insurer will not process a surrender on a collaterally assigned policy without a release or written consent from the assignee.
The bank may also impose conditions: replacement coverage of at least the loan balance, or a reduction of the operating loan. That matters here because Robert's only other coverage is $150,000 of group life that terminates at retirement - a shrinking asset securing a loan that may still be outstanding.
Practical answer: Robert's first call is to the bank, not the insurer. If he surrenders without clearing the assignment, any cash value released may be applied to the loan, and he may find he has less than he planned - plus a policy he can never replace at age 58 in the same health.
2. Calculate the tax result of a full surrender and compare it with the reduced paid-up and increased-loan options.
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On a disposition of a life insurance policy, the policy gain is the proceeds of disposition minus the adjusted cost basis, and it is included in income as ordinary income - not as a capital gain, and with no inclusion-rate discount.
The proceeds are the full cash surrender value, even though part of it is used to repay the policy loan, because Robert is entitled to the whole $94,000 and has $30,000 of debt discharged out of it.
- Proceeds: $94,000
- ACB: $41,000
- Policy gain: $53,000, fully taxable
- Net cash after loan repayment: $64,000
- At a 45% marginal rate, roughly $23,850 of tax, leaving about $40,150 for the RRSP and line of credit - well short of the $100,000 he planned.
Reduced paid-up: Robert stops paying premiums and the policy continues at a smaller death benefit, still subject to the loan. There is no disposition and no policy gain. The problem is that the loan plus capitalized interest must be serviced or repaid, and the reduced death benefit may barely exceed the loan.
Larger policy loan: Provides cash without triggering the gain, but only up to the cash value, and the 6% capitalised interest compounds against the policy. Borrowing to make an RRSP contribution only makes sense if the deduction and growth outweigh the interest - and he would be borrowing against his own death benefit to do it.
3. Set aside Robert's preference. What is the sound recommendation, and what would you say about the RRSP deadline pressure?
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The deadline is a sales pressure, not a planning reason. Advise on need first.
Robert's actual exposures are: a $300,000 mortgage, children in university, a $250,000 operating loan secured partly by his own life insurance, and a business interest that will trigger tax on death (deemed disposition of shares, possibly a capital gain) that his estate will have to fund. Against that he has $500,000 of permanent coverage he can never re-buy at 58, and $150,000 of group coverage that vanishes exactly when the estate tax bill could arrive.
Surrendering the permanent policy to make a $60,000 RRSP contribution trades a tax-free death benefit and an estate liquidity asset for a fully taxable disposition now and one year of RRSP room. The arbitrage does not work: he pays roughly $24,000 of tax to get a deduction of perhaps $27,000, and he destroys a $500,000 asset in the process.
A defensible recommendation might combine: (1) repay or restructure the policy loan so the 6% capitalised interest stops eating the cash value; (2) reduce the premium by switching part of the coverage to a lower-cost term rider or a reduced paid-up base, keeping the permanent death benefit for estate liquidity; (3) fund the RRSP from cash flow or a modest business draw instead; (4) revisit the collateral assignment alongside the operating loan renewal.
Whatever the recommendation, document the alternatives presented, the numbers given, and Robert's decision - this file will look very different to an errors-and-omissions examiner if the surrender happens and he dies two years later.