How Life Insurance Is Taxed In Canada: What You Need To Know Before Making Withdrawals, Claiming Benefits

Death is an inevitable end that awaits every individual, and no one knows the time at which it may come. One meaningful gift that many Canadians choose to leave for a loved one—without the complexities of a will—is a life insurance payout. If one intends to give this kind of gift, it is prudent to understand how it may be taxed in the hands of the beneficiary upon withdrawal. It is also important to be aware of the tax implications that may arise from certain other withdrawals, payouts, or related activities involving a life insurance policy. This article aims to discuss these considerations.

Tax Implications of Life Insurance Withdrawals and Payouts in Canada

Upon death, the benefits from a life insurance policy generally pass tax-free to the designated beneficiaries. Outside of this straightforward scenario, other withdrawals, payouts, or related activities involving a life insurance policy will likely be subject to taxation.

For example, taxes will apply in the following circumstances:

• If the policyholder cancels the insurance policy and receives payouts that exceed the adjusted cost base of the policy.
• If the policyholder withdraws from the cash surrender value of the policy, and the withdrawal exceeds the adjusted cost base.
• If there was no beneficiary designated at the time of death, resulting in the insurance policy passing to the estate, which may incur probate fees or other taxes.
• If the life insurance policy is sold in provinces where such sales are permitted, such as Quebec and Saskatchewan.
• If the policyholder borrows from the policy and the policy lapses while the loan is still outstanding, making the loan amount taxable.
• If the payout of the insurance benefit is delayed after death, and interest accrues against the insurance company, such interest paid to the beneficiaries will be taxed.
• If the beneficiary chooses with the insurance company to delay the insurance benefits payout to allow it to accrue interest, dividends, or other income, the eventual payout of those accrued amounts will be subject to tax.

These foregoing taxes are assessed as income taxes, rather than capital gains taxes.

Where life insurance benefits are received tax-free, the beneficiaries are not required to file tax returns or report such benefits as income. However, in cases where life insurance payouts are taxable, the recipient will receive a T5 form from the insurance company, which will be used to file the appropriate tax returns.

Pro Tax Tips: Avoid Costly Mistakes: The Importance of Expert Advice for Life Insurance Withdrawals in Canada

Aside from the usual payment of death benefits to a beneficiary upon the death of the policyholder, other types of payouts or withdrawal-related activities from the life insurance policy—whether by the beneficiary, policyholder, or another applicable person—should be undertaken only after consulting an experienced Canadian tax lawyer.

Various options exist that could help reduce tax liabilities. For example, particularly with permanent life insurance policies, it is possible to transfer amounts that would ordinarily be taxable upon withdrawal into tax-sheltered accounts such as a Tax-Free Savings Account (TFSA), Registered Retirement Savings Plan (RRSP), and others.

Additionally, borrowing from the cash surrender value of your life insurance policy will accrue interest. If the interest and associated fees exceed the policy's cash surrender value, the policy could lapse, resulting in a loss of coverage.

Even if the policy does not lapse, and the policyholder dies while the loan remains outstanding, the loan balance and interest owed will be deducted from the death benefits payable to the beneficiaries.

Furthermore, using a life insurance policy as collateral for a loan gives the lender priority to recover the loan amount and interest over the death benefits paid to the beneficiaries.

Many withdrawal mistakes occur because taxpayers fail to seek proper tax advice. Consulting expert Canadian tax lawyers can help prevent these costly errors.

Frequently Asked Questions (FAQs):

What is the adjusted cost basis of a life insurance policy?

The adjusted cost basis of a life insurance policy roughly represents the total premiums paid toward the policy, minus certain deductions. The calculation is as follows: total premiums contributed to the policy, minus the cost of insurance, plus or minus other adjustments such as loans and dividends.

What is the "Cash Surrender Value" of a life insurance policy?

Cash surrender values are typically associated with certain permanent life insurance policies. These amounts are set aside from the premiums paid, according to a formula established in the policy. Cash surrender values can be reinvested to generate additional income and remain tax-deferred while they grow within the policy.

The government may impose limits on the amount of cash surrender value a policy can accumulate or the income generated from it. The insured may withdraw or borrow against the cash surrender value during their lifetime. However, withdrawals from the cash surrender value are taxable if such withdrawals exceed the adjusted cost base of your policy.

Will borrowing from a life insurance policy be taxed?

Borrowing from a policy generally involves taking a loan against the cash value. No tax is payable when borrowing, provided the policy remains active.

Does borrowing against the cash surrender value reduce the compounding of my total cash surrender value?

Not necessarily. Most insurers include provisions in their policies to prevent the total cash surrender value from depleting when a portion is borrowed. This means the total cash surrender value can continue to grow uninterrupted. This differs from a withdrawal, which reduces the cash surrender value. However, if the insured dies while the loan balance and accrued interest remain unpaid, these amounts will be deducted from the death benefits payable to beneficiaries.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.