Life Insurance Proceeds: Taxable In Canada?

Life insurance is generally non-taxable in Canada, meaning that beneficiaries won't have to pay income tax on the amount they receive when the policyholder dies. This is true regardless of the size of the policy or the beneficiary. However, there are certain situations in which life insurance proceeds may be taxed. For example, if no beneficiary is appointed, the estate will become the beneficiary, and the death benefit may be subject to tax. Additionally, if the policy has been used as collateral for a loan, the beneficiary may have to pay taxes on any outstanding loan balance that exceeds what was paid into the policy. In some provinces, it is also possible to sell a life insurance policy, and the money received from this sale may be taxed.

Naming your estate as your beneficiary

In Canada, if you name your estate as your beneficiary, your executor will be responsible for distributing your estate, including your pension benefit, according to the instructions in your will. However, if you die without a will, the court will appoint someone to administer your estate, which will delay the payment of your pension benefit.

There are several reasons why someone might choose to name their estate as the beneficiary of their life insurance policy. One reason is that it is a way of creating more cash in your estate. The estate doesn't have to pay tax on the life insurance money it receives. This is beneficial for business owners who want to leave something in the estate for their children who are not inheriting the family business. It also allows individuals to leave insurance money in their estates to pay the capital gains tax on properties so that they can be kept in the family. Additionally, a person with lots of debt or taxes might leave life insurance to cover those debts or taxes.

However, there are also tax implications if your death benefit goes towards your estate instead of directly to a person. In this case, the amount could be subject to tax, and there may be additional settlement costs (e.g. accounting, legal, executor fees) during the money distribution process. Therefore, it is generally recommended to appoint beneficiaries directly on your life insurance policy to prevent added fees and taxes and speed up the overall settlement process.

Withdrawing from a permanent policy's cash value

Understanding Permanent Life Insurance

Permanent life insurance, such as whole life and universal life, offers lifelong coverage and doubles as an investment vehicle. It accumulates a cash value over time, providing a living benefit that you can access while alive. This cash value grows tax-advantaged, and you can withdraw it for various purposes, including personal or practice opportunities, funding children's education, boosting retirement income, or dealing with emergencies.

Options for Withdrawing Cash Value

There are several ways to access the cash value of a permanent life insurance policy, each with its advantages and disadvantages:

• Policy Withdrawal: You can withdraw from the accumulated cash value, but this reduces the total cash value and future growth and decreases the death benefit. Withdrawals exceeding the pro-rated policy adjusted cost basis (ACB) are considered taxable income.
• Policy Loan: You can take out a loan against the accumulated cash value, which is provided by the insurer with interest. The policy continues to grow uninterrupted, and any outstanding loan balance, including interest, is deducted from the death benefit upon your death.
• Surrender Policy: You can surrender the policy in whole or in part at any time to receive its cash surrender value. However, this will result in the termination of the policy and the loss of coverage.
• Collateral Loan or Line of Credit: You can use the cash value as collateral to secure a loan or line of credit from a third-party lender. This option has greater risk and administrative requirements but offers the advantage of no personal or corporate tax on loan advances under current tax rules.

Tax Implications of Withdrawing Cash Value

Withdrawing from a permanent life insurance policy's cash value can have tax consequences. If you withdraw more than the amount you've contributed to the cash value, that portion is typically taxed as ordinary income, not capital gains. The insurance company will determine the taxable amount and send a T5 tax slip if necessary. Additionally, if you surrender the policy and the cash value exceeds the adjusted cost base (ACB) of the policy, the excess is treated as taxable income.

Considerations

When considering withdrawing from a permanent life insurance policy's cash value, it's important to weigh the benefits against the potential drawbacks. Cashing out may not be the most tax-efficient option, and it's essential to understand the tax implications beforehand. Additionally, withdrawing funds will reduce the death benefit for your beneficiaries. Consult with a financial or tax professional to ensure you make the best decision for your specific circumstances.

Cancelling your permanent policy

Cancelling your permanent life insurance policy is a straightforward process, but there are a few key things to keep in mind. Here's a step-by-step guide:

• Understand the implications of cancelling: Before initiating the cancellation process, it's important to consider the reasons behind your decision. Cancelling a permanent policy can have repercussions, especially if your beneficiaries depend on the coverage. Ask yourself if you still require coverage, if you've found a better policy, or if the cost is the main factor.
• Review your policy documents: Before taking any action, carefully review the terms and conditions of your permanent life insurance policy. Pay close attention to any clauses related to cancellation, as well as the surrender period and any associated fees. Understanding these details will help you make an informed decision and avoid unexpected costs.
• Contact your insurance provider: Get in touch with your insurance provider to discuss your intention to cancel. They can guide you through their specific cancellation process and address any questions or concerns you may have.
• Submit a cancellation form: Some insurance providers offer the convenience of online cancellation. Check if your insurer provides this option, or if they require a completed cancellation form to be mailed or faxed. This form will require basic information, such as your name, address, policy number, and the desired cancellation date.
• Send a written notice: If you prefer, or if required by your insurer, you can send a written letter to the insurance company stating your intention to cancel the coverage. Be sure to include your name, address, policy number, cancellation date, and any other relevant details.
• Stop paying premiums: For term life insurance policies, stopping premium payments may be sufficient to cancel the policy. However, for permanent life insurance, simply halting payments may not be enough, as the policy has an inherent savings component.
• Surrender the policy for its net cash value: Permanent life insurance policies, such as whole life and universal life, accumulate wealth over time. When you cancel these policies, you can surrender them and receive their net cash value, minus any applicable surrender fees. The longer you've held the policy, the closer the net cash value will be to the actual cash value.
• Consider reduced paid-up insurance: If you're looking to reduce your premium payments but still want some level of insurance protection, reduced paid-up insurance may be an option. Your insurer can cancel your existing policy and use its cash value to fund a new policy with a guaranteed but lower death benefit.
• Be mindful of fees and taxes: Cancelling a permanent life insurance policy may incur surrender fees and taxes. These charges will be deducted from the cash value of your policy, reducing the net amount you receive.
• Explore alternative options: Before cancelling your permanent policy, consider alternative options such as switching to a policy with a shorter term or a lower death benefit, or transferring your policy's cash value to a different investment vehicle.

Remember, life insurance is a vital tool for protecting your loved ones financially. While cancellation may be necessary in certain circumstances, carefully evaluate your options and consider seeking professional advice to ensure you make the best decision for your situation.

Interest earnings for your beneficiaries

Interest earnings on a life insurance policy are taxable in Canada. If your beneficiaries receive interest from the cash value of your policy, it will be taxed as income. The interest can be taxed by the Canada Revenue Agency (CRA).

The taxation of interest earnings from a life insurance policy depends on the type of policy you buy: term or permanent. Term life insurance death benefits are not taxable in Canada, unless your policy does not have a named beneficiary. Permanent life insurance policies, such as whole and universal, are more likely to have tax implications, like paying tax on cash value.

If your beneficiaries receive any money from interest or dividends from your life insurance policy, they will pay tax on the amount. Earnings on the payout of life insurance are subject to income tax on earned interest, dividends, and realised capital gains on those invested monies, unless they're invested in another tax-sheltered plan, such as a tax-free savings account.

If you do need to pay taxes on interest earnings, your insurer will send a T5 slip, outlining the amount you owe to the government. You can then report the earnings on line 12100 of your tax return.

Selling your permanent policy

Selling your permanent life insurance policy is a big decision and should only be done after careful consideration. It is important to note that not all provinces or life insurance companies in Canada allow policyholders to sell their personal life insurance policies. Additionally, selling a permanent life insurance policy is typically easier than selling a term life insurance policy.

• Tax implications: Selling your life insurance policy has complicated tax implications. The proceeds from the sale are considered income and are therefore taxable. This is the case regardless of whether you sell to a third party or a family member.
• Alternatives to selling: Before selling your policy, consider other options such as reducing the coverage amount, cancelling the policy (if it is relatively new), or using the accelerated benefit rider if you have a terminal illness.
• Age and health: Your age and health will impact the offers you receive for your policy. Younger and healthier people tend to receive lower returns from a life settlement, if they qualify at all. Most buyers look to purchase policies from individuals aged 65 or older.
• Find a reputable broker: It can be challenging to find buyers for your policy on your own. While hiring a broker can help, be mindful that their commission rates can vary significantly, so it is worth interviewing several brokers before making a decision.
• Get multiple quotes: Whether you sell your policy on your own or through a broker, be sure to get as many quotes as possible to ensure you are getting the best price.
• Insurers may not allow life settlements: Not all life insurance companies permit policyholders to sell their life insurance. For example, Sunlife Insurance does not allow life settlements, regardless of the province of residence.
• Not legal in all provinces: Selling a personal life insurance policy is not permitted in all provinces. For instance, while Quebec and Saskatchewan allow life settlements, Ontario does not.

Remember, selling your permanent life insurance policy is a significant decision that should be made only after exploring all your options and considering the potential tax implications.

Frequently asked questions