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Is Life Insurance Taxable in Canada? Here’s What You Must Know

SUMMARY

In general, the death benefit of life insurance is not taxable. However, there are components of estate transfer, dividends, or interest income from life insurance that may be taxable. Premium payments made for life insurance policies may be tax-deductible depending on how the policy is used.

IN THIS ARTICLE

Let’s face it: tax returns can be confusing. Come tax season in April, you have to collect all your tax slips, plug them into a reporting system, and either hope you did them right or pay someone to make sure they’re done right. 

After receiving a life insurance payout, your beneficiaries may be worried that the money is taxable. They may have other questions too. Is the life insurance payout taxable? Are whole life policies subject to taxes? Are premiums on life insurance deductible? 

Life insurance payouts are generally not taxable in Canada. Death benefits made directly to named beneficiaries are tax-free, and beneficiaries don’t need to report the money as additional income. But like many things related to tax or life insurance, there are always exceptions! Policies that generate interest or dividend income, flow through an estate, offer a policy loan, or offer cash withdrawals can lead to tax consequences.

Proper structuring of your policy can help your loved ones continue living their lives with minimal tax consequences. In this article, we’ll help you figure out what you need to know about taxes when purchasing a life insurance policy. These tips will help your family receive the most money without the tax burden.

Is a life insurance benefit taxable for a beneficiary?

Beneficiaries do not pay tax on life insurance payouts in Canada. If you name your spouse, child, or any other individual or entity (like a charity) as a beneficiary on your life insurance policy, the proceeds will be tax-free when paid to them. The beneficiary does not have to declare the proceeds as taxable income on their annual CRA returns. 

Appointing a beneficiary in your life insurance policy has several advantages:

  • Proceeds are paid-tax free
  • Proceeds do not have to go through probate
  • Proceeds do not become a matter of public record

You should always appoint a beneficiary on your policy to ensure that the proceeds from your life insurance policies go to the beneficiaries of your choice, rather than directly to your estate or creditors. If you choose not to appoint a beneficiary, then your estate will automatically be designated as the beneficiary. When this happens, the life insurance funds become a part of the pool of estate assets. The life insurance money can then be used to cover any outstanding debts on the estate and may be subject to other administrative fees and probate taxes—meaning less money for your family.

When can life insurance become taxable?

Life insurance can become taxable in several scenarios in Canada:

  • Policy surrender or lapse: If you surrender your policy or it lapses with an outstanding loan, the loan amount may be taxable
  • Policy transfers: Transferring ownership to someone other than a spouse or qualifying trust can trigger taxes on accrued gains
  • Excess withdrawals: Withdrawals exceeding the amount of premiums paid are subject to income tax
  • Policy loans: If a policy loan is not repaid and the policy lapses, the loan amount may be taxable

Taxes on policy loans, cash withdrawals, collateral assignments

During your lifetime, you can access your permanent life policy’s cash value in three ways: a policy loan, withdrawal, or collateral assignment. Each method has different tax consequences. 

Policy Withdrawals
Permanent life insurance can grow in cash value and provide you with a potential source of future funds. Most policies with cash values allow you to withdraw some or all of the cash value (for a fee). However, these withdrawals are generally taxable. This withdrawal will be taxed whenever the amount withdrawn exceeds the policy’s corresponding Adjusted Cost Basis (ACB).

Policy details Value
Policy cash value $100,000
Adjusted Cost Basis (ACB)  in policy $75,000 

(ACB is 75% of policy’s cash value)

Policy withdrawal  $20,000
Amount of withdrawal treated as ACB $15,000 (75% of $20,000)
Withdrawal amount that is taxable $5,000 ($20,000-$15,000)

Policy loans

A policy loan is a borrowing from the insurance company secured by the cash value of the policy. Think of it like taking an advance on your policy’s death benefit. It’s different from a withdrawal in that, you can repay this loan, so your death benefit doesn’t take a hit. Policy loans amounts that are equal to or less than the policy’s ACB are non-taxable. But policy loans taken in excess of the policy’s ACB will be taxable. In such a case, the insurance company will issue a T5 slip to report the taxable gain. 

Policy details Value
Policy cash value $100,000
Policy loan $80,000
Adjusted Cost Basis  $75,000
Taxable gain (same as the amount in excess of ACB) $5,000

Policy as collateral
A policy owner can take a loan from a third-party institution, such as a bank, using the cash value as collateral on the loan. Generally, loans will be structured as a line of credit and the loan proceeds will be received tax-free. Upon the death of the insured, the proceeds from the life insurance policy are used to pay off the line of credit and any unpaid interest on the loan. If you repay the policy loan during your lifetime using your own funds then there will be no tax impact.

Policy withdrawal Policy loan Policy as a collateral assignment
Access to cash value (%) Up to 100% (minus any surrender fees) Up to 90% 50-90%
Taxable? Only amount in excess of the policy ACB When loan exceeds ACB, whole loan amount is taxed Tax-free
Considers what you’re using the money for? No No Yes
Uses your credit score to determine loan amount? No No Yes
Reduces death benefit? Yes Yes, if you don’t repay the loan. No

When can I claim my life insurance on my tax return?

The rules around reporting your life insurance premiums and payouts on your tax returns depend on how you are using your insurance and the kind of policy you have. For example, a life insurance death benefit payout is not reported as taxable income. However, if you receive the interest or dividends as cash,  you need to report the cash received as income on your personal tax return. Similarly, any gains on policy withdrawals or loans have to be reported. 

If a policy loan OR withdrawal is part of corporate-owned life insurance (COLI), the taxable income is reported on the corporation’s tax return instead. 

It’s ideal to speak with a tax professional to learn exactly how your life insurance proceeds are taxed.

Can I claim life insurance premiums on my income tax?

The tax deductibility of life insurance premiums is complex. In most cases, premiums aren’t tax-deductible for individuals or businesses. But there are some exceptions. For instance, if you use your policy as loan collateral or borrowed money through a policy loan and then use the loan proceeds in business activities, premiums could be deductible. This is possible whether it’s a personally-paid life insurance policy or a corporate-paid policy. 

The following criteria must be followed to claim your premiums related to a policy loan:

  • Policy must be collaterally assigned for a loan from a “restricted financial institution” as defined by the Income Tax Act (this includes a bank, trust company, insurance company, or credit union); 
  • Interest payable on the loan must be otherwise deductible from the policyholder’s income;
  • Policyholder must be the borrower; and, 
  • Assignment of the death benefit must be made to the lender as collateral for the debt.

It’s important to note that assigning the death benefit to the lender does not trigger a tax consequence. Additionally, the policyholder can deduct the lesser of the premiums they actually pay for the Net Cost of Pure Insurance (NCPI), an amount that the insurance calculates for tax purposes.

Claiming your personally paid life insurance

Suppose you have a permanent life insurance policy with a cash surrender value of $500,000. A financial institution might offer to loan you $450,000 based on your policy’s value. During this time, you still need to make premium payments on the life insurance policy. 

After taking the loan, you use the $450,000 to purchase, renovate, and flip a property. Profits from this business venture are taxed as business income on your personal tax return. 

In this situation, your life insurance premiums are likely deductible because you’re using the loan proceeds for business activities or property.

You may also be able to a tax credit if you donated your policy to a charitable institution and kept making the premium payments to keep the policy in force. 

Claiming your business or corporate paid life insurance

A corporation can also deduct life insurance premiums when it uses a policy as loan collateral, assuming that all the other criteria listed above are met. 

In addition, businesses can deduct premiums where it pays premiums on behalf of their employees. These costs are deductible and are treated as payments to employees, like health and dental benefits, or disability insurance. 

A corporation can pay its shareholder’s life insurance premiums, suggesting that the shareholder is also an employee, and the premiums are paid in the shareholder’s capacity as an employee. 

How can I avoid paying taxes on life insurance?

As mentioned before, life insurance payouts aren’t taxable. However, working with an experienced tax accountant or lawyer is the best way to avoid paying tax for any nuanced life insurance policies (such as ones that pay dividends). For most people, this might mean naming primary and contingent beneficiaries so that your death benefit won’t go through your estate and be subject to probate fees. 

However, if you take a policy loan, cash withdrawal, or use the cash value as collateral, significantly more complex tax consequences are at play. The same is true when dealing with corporate-owned life insurance. 

These transactions might generate numerous tax liabilities, so it’s best to speak to a tax professional and expert insurance advisor to understand your tax reduction options.

PolicyAdvisor’s licensed insurance experts can inform you what life insurance products are best for your situation and how to reduce the taxability of your death benefit. Book some time with us below to see how you can structure your life insurance needs in the most tax-efficient manner. 

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How does taxation of life insurance premiums and contributions work in Canada?

In Canada, life insurance premiums are generally not tax-deductible. Here’s how this works:

  • Tax deductibility: In Canada, premiums paid for personal life insurance policies are generally not tax-deductible on personal income tax returns. This means individuals cannot claim these premiums as expenses to reduce taxable income
  • Business-owned policies: There are exceptions for business-owned life insurance policies where premiums may be deductible as a business expense, depending on the purpose and structure of the policy

Tax-deferred growth: While premiums are not tax-deductible, the cash value within the policy grows tax-deferred. This means any earnings on the policy’s cash value are not taxed until they are withdrawn from the policy

How does taxation of life insurance cash values and withdrawals work in Canada?

The cash value accumulated in a life insurance policy grows tax-deferred in Canada, meaning you do not pay taxes on the gains as they accrue. When you decide to withdraw or take a loan against the cash value, the tax treatment varies. 

Withdrawals are generally tax-free up to the amount of premiums paid into the policy. Any amount withdrawn over the premiums paid is considered taxable income. 

Additionally, policy loans are not taxable as long as the policy remains in force. However, if the policy lapses or is surrendered, the outstanding loan balance may be subject to tax, so careful planning is essential.

How does taxation of life insurance policy transfers work in Canada?

Transferring a life insurance policy can have significant tax implications in Canada. If you transfer ownership of a life insurance policy, the transfer may be considered a taxable event, depending on the circumstances. Here’s how the taxation works:

  • Taxable transfers: Transferring ownership of a life insurance policy to another individual or entity can trigger tax consequences
  • Tax-free transfers: Transfers to a spouse or a qualifying trust are typically tax-free, preserving the policy’s tax-deferred status
  • Taxable gain: If the policy has accumulated cash value and is transferred for consideration (e.g., sale), any gain may be subject to capital gains tax
  • Consultation recommended: Consulting with a tax professional is advisable before transferring a policy to understand and mitigate potential tax liabilities

How does taxation of life insurance policy transfers work in Canada?

Transferring a life insurance policy can have significant tax implications in Canada. If you transfer ownership of a life insurance policy, the transfer may be considered a taxable event, depending on the circumstances. Here’s how the taxation works:

  • Taxable transfers: Transferring ownership of a life insurance policy to another individual or entity can trigger tax consequences
  • Tax-free transfers: Transfers to a spouse or a qualifying trust are typically tax-free, preserving the policy’s tax-deferred status
  • Taxable gain: If the policy has accumulated cash value and is transferred for consideration (e.g., sale), any gain may be subject to capital gains tax
  • Consultation recommended: Consulting with a tax professional is advisable before transferring a policy to understand and mitigate potential tax liabilities

How does life insurance help in tax planning?

Life insurance can be a powerful tool in tax planning in Canada. It offers various benefits, including tax-deferred growth of cash values, tax-free death benefits to beneficiaries, and the potential for tax-free withdrawals under specific conditions. 

Here are some things you must bear in mind about tax planning with life insurance:

  • Estate planning: Life insurance plays a crucial role in estate planning by providing tax-free death benefits to beneficiaries
  • Tax-deferred growth: The cash value growth within certain policies, like Whole Life or Universal Life, is tax-deferred
  • Estate tax mitigation: Life insurance proceeds can help cover estate taxes, ensuring assets are passed to heirs without undue tax burden
  • Flexibility: Policies can be structured to offer flexibility in premium payments and death benefits, optimizing tax efficiency based on individual financial goals
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Frequently-asked questions

Is life insurance payout taxable on death?

No, death benefits paid from a life insurance policy are generally not taxable income in Canada.

What is the tax implication of withdrawing cash from a life insurance policy? 

Withdrawals up to the total premiums paid into the policy are typically tax-free. Amounts exceeding premiums may be subject to income tax.

Are life insurance death benefits included in calculating an estate’s taxes in Canada? 

Generally, life insurance death benefits are not included in the calculation of an estate’s taxes in Canada, as they are typically tax-free.

Can I transfer ownership of a life insurance policy without triggering a taxable event? Transferring ownership to a spouse or a qualifying trust is typically tax-free in Canada. However, transferring to others may trigger taxes on any accrued gains.

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KEY TAKEAWAYS

  • The life insurance death benefit payout is not taxable
  • If you earn interest or dividends on policies, that may be taxed
  • Policy loans or withdrawals may be taxed
  • Estate transfers may have tax implications that can be covered by life insurance

By Jiten Puri
CEO & Founder, Insurance Advisor, LLQP
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