Is life insurance taxable in Canada?
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.
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.
Does a beneficiary have to pay taxes on a life insurance policy
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 due to interest or dividend income from participating life insurance policies, estate administration taxes, or when taking out a policy loan, cash value withdrawal, or collateralization.
Taxes on policy dividends
Participating whole life insurance and universal life insurance policies can accumulate dividends and interest. These dividends aren’t taxable if they are reinvested within the policy, allowing you to grow your policy’s cash value on a tax-sheltered basis. The accumulated value is paid out as part of the tax-free death benefit when the insured person passes away.
However, you will be subject to tax on any interest or dividends you don’t reinvest or receive in cash. For example, some use their policy interest payments or dividends to supplement their retirement income—the interest payments or dividend payout would be taxable in this case.
Reporting dividends and interest on your tax return (lines 12010 and 12100)
If you owe taxes on interest and dividends earned from your life insurance, your insurer issues you a T5 slip. You then must report the dividend income on lines 12000 and 12010 and interest income on line 12100 on your tax return.
Taxes on your estate when you don’t name a beneficiary
When you pass away, most of your assets go through your estate. When you have a named beneficiary on your policy, the life insurance payout bypasses your estate and goes directly to your beneficiaries, tax-free. If you don’t name a beneficiary on your life insurance policy, the life insurance payout goes through your estate.
Money in your estate first repays any secured or unsecured creditors, including any unpaid income taxes (for example, taxes on any capital gains from that year). The remainder is subject to probate fees, otherwise known as estate administration tax, and estate settlement costs like executor, legal, and accounting fees, which can all add up.
Your family or rightful heirs would not receive any portion of the proceeds until these outstanding debts and settlement costs are satisfied. By naming a beneficiary, you can prevent added fees and taxes and speed up the settlement process.
Taxes on policy loans, cash withdrawals, collateral assignments
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 cash value||$100,000|
|Adjusted Cost Basis (ACB) in policy||$75,000
(ACB is 75% of policy’s cash value)
|Amount of withdrawal treated as ACB||$15,000 (75% of $20,000)|
|Withdrawal amount that is taxable||$5,000 ($20,000-$15,000)|
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 cash value||$100,000|
|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 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.
- 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