Buying life insurance gives you peace of mind knowing that your family and loved ones will be financially protected should something to you. Your insurance company pays out a death benefit to your designated beneficiary when you die.
Your beneficiary can use the policy’s death benefit to cover your final expenses, pay off your debts, manage everyday living expenses and meet your family’s future needs.
However, what happens when your loved ones receive your policy’s death benefit? Is life insurance taxable in Canada? Will your beneficiary have to pay income tax on their inheritance?
This blog post discusses life insurance and the tax implications it might have.
Is Life Insurance Taxable In Canada?
Life insurance in Canada is not taxable. Beneficiaries do not have to pay taxes on life insurance payouts. Your beneficiary will get every dollar of the lump-sum death benefit and can use it to finance anything they please.
Like other financial gifts and inheritances, life insurance payouts are non-taxable under the Canada Revenue Agency (CRA). Your beneficiaries do not need to report the death benefit payout as additional income on their tax return.
The death benefit paid from your policy is tax-free and can be used to pay off debts, like the mortgage, so your family can remain in your family home. It can be used to replace your income to help your family maintain their standard of life.
Your beneficiaries can also use your tax-free death benefit to pay for your funeral expenses, preserve your assets and provide for your children and dependents.
No insurance policy in Canada is taxable regardless of the size, and type of insurance policy you purchase, whether term life or permanent life insurance.
When Will Life Insurance Become Taxable?
Life insurance isn’t taxable in Canada. However, there are a few exceptions. Life insurance can be taxable when there are interest or dividend incomes from your policy, when you take policy loans, withdraw from the cash value, or estate administration taxes.
Taxes on Estate When you Don’t Name a Beneficiary
When you die, your assets go directly through your estate. However, when you designate a beneficiary on your life insurance policy, your death benefit bypasses your estate and goes tax-free to your beneficiary.
But if you don’t name a beneficiary on your policy, your death benefit goes through your estate. The money first repays all your secured or unsecured creditors, which includes unpaid income taxes,
The balance of the death benefit is subject to probate fees (estate administration tax) and estate settlement costs, including legal, executor, and accounting fees.
Your family and loved ones will not receive any portion of the death benefits until all these outstanding debts and settlement costs are paid off. By naming a beneficiary, you can avoid these fees and taxes and speed up the settlement process.
Taxes on Policy Loans, Cash Withdrawals, and Collateral Assignments
During the lifetime of your permanent life insurance policy, you can access the cash value through policy loans, withdrawals, or collateral assignments.
Each of these has tax implications. When you withdraw money from the policy’s cash value, the withdrawal will be taxed when the funds withdrawn exceed the policy’s corresponding Adjusted Cost Basis (ACB).
Also, when you take a policy loan, you borrow from the insurer secured by the policy’s cash value. You are simply taking an advance on your policy’s death benefit. You can repay the loan, so your death benefit payout does take a hit. Policy loan amounts equal to or less than the ACB of your policy are non-taxable. However, when you take loans that exceed the policy’s ACB, they will become taxable.
Further, when you take a loan from a third-party institution, like a bank, using the policy’s cash value as collateral, the loans are structured as a line of credit and are received tax-free. However, if you die without paying back the loans fully, the portion of your death benefit used to pay off the loan will be taxable.
Taxes on Policy Dividends
Some life insurance policies, like participating whole life insurance and universal life insurance, accumulate dividends and interests. If you choose to reinvest these dividends within the policy to grow your policy’s cash value, the dividends aren’t taxable.
However, if you don’t reinvest the dividends and choose to receive them in cash, you will be subject to paying tax on the interests and dividends. Your insurance company will issue you a T5 slip if you owe taxes on dividends earned on your life insurance. You must report the dividend incomes on lines 12000 and 12010 and the interests on lines 12100 on your tax return.
How Can I Avoid Paying Taxes on Life Insurance?
Losing a loved one will be hard for your family. Don’t let them go through another hassle in claiming your life insurance policy. You can make it easy for them and help avoid taxes on the death benefit.
Suppose you properly file the name of your beneficiary or beneficiaries on your life insurance policy. In that case, you can speed up the settlement process for your loved ones and help avoid probate fees and associated costs.
Let your beneficiaries know you have named them on your insurance policy. Please provide them with the insurance provider’s details so they can easily file a death claim.
You need to amend your policy’s information with every change you make in life, getting married, divorced, giving birth, or adopting a child. Also, name a contingent beneficiary, so they can receive the death benefit if the primary beneficiary passes away or is unavailable.
If you take policy loans, withdraw cash from your policy, or use the cash value as collateral, it’s best to speak with a tax professional or an expert insurance advisor. They can help explain your tax reduction options.
When Can I Claim My Life Insurance On My Tax Return?
You should speak to a tax professional or an insurance advisor to learn precisely how your life insurance payouts are taxed. The rule on reporting life insurance premiums and proceeds depends on how you use your life insurance policy and what kind of policy you have.
While life insurance payout is not reported as taxable income in Canada, if your receive dividends or interests in cash, you must report the cash as income on your tax return.
Also, all excess on policy withdrawals and loans should be reported.
Is The Cash Value of Life Insurance Taxable?
Permanent life insurance, whole or universal, has a built-in cash value that can be used for investing. As you pay premiums on your permanent life insurance policy, a portion of the premium goes to the cash value. The cash value accumulates and grows over time.
If you choose to surrender your permanent life insurance policy or withdraw money from the cash value, you will pay taxes on your earnings. When you die, if your beneficiaries receive interest from your policy, they will have to pay tax on the amount.
Life insurance cash value grows tax-free and is exempt from taxation until you withdraw the money. If you need to pay tax on the policy’s cash value, your insurer will notify you with a T5 slip outlining the amount you should pay to the government. Then, you can report the earnings on line 121 of your tax return.
Final Thoughts on Is Life Insurance Taxable In Canada
In a nutshell, life insurance isn’t taxable in Canada. There are only a few outliners you should be aware of.
If you are in doubt about your coverage and whether any part of your life insurance policy may be taxable, you should speak to an expert insurance advisor.
Hi, I'm Adeola Adegoke. I am a licensed Insurance Broker in Manitoba, and I hold a master’s degree in Mathematical Sciences (with a major in Financial Modeling) from the African Institute for Mathematical Sciences (AIMS), Tanzania.
Also, I have a second master's degree in Statistics from the University of Regina, and I am currently pursuing my Ph.D. in Statistics at the University of Manitoba.
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