Life Insurance Payouts: Taxed In Canada?

Life insurance payouts are generally not taxed in Canada. Death benefits are paid directly to beneficiaries in one tax-free lump sum, and beneficiaries don't need to report the payout as additional income on their Canadian tax return. However, there are certain scenarios in which life insurance payouts may be taxed. For example, if you don't name a beneficiary, your estate will become the beneficiary and the death benefit will be subject to estate taxes. Withdrawing from the cash value of a permanent life insurance policy may also be taxed. Additionally, if your beneficiaries receive interest earnings from your policy, this interest may be taxed as income. Proper structuring of your policy is important to ensure your loved ones receive the most money with minimal tax consequences.

Naming a beneficiary

You can name multiple beneficiaries and decide how you want the money to be split between them. Usually, the best way to divide the money is by percentage. For example, 50%/50%, 65%/35%, or 50%/25%/25%.

When choosing a beneficiary, most people name a close relative, such as a spouse, sibling, or child. However, you can also choose a more distant relative or a friend. If you want to name a friend as your beneficiary, it is a good idea to check with your insurance company or your state, as some states require beneficiaries who aren't relatives to have an "insurable interest in your life" when you take out the policy. This means that they could suffer financially if you were to die.

In addition to naming primary beneficiaries, you can also name secondary or contingent beneficiaries. A secondary beneficiary will receive your payout if both you and your primary beneficiary die at the same time. Without a contingent beneficiary, your payout would likely go to your estate and be subject to estate taxes.

To name a beneficiary, simply fill out the relevant section of your life insurance policy application form. After the insurance company approves your policy and it goes into effect, your beneficiary is set. You can change your beneficiary at any time by requesting a beneficiary designation form from your insurance company.

It is important to keep your beneficiary designations up to date, especially after major life changes such as marriage, divorce, or the birth of a child. You can also name minors as beneficiaries, but you should also appoint an adult guardian for the child in your will or create a trust.

Interest earned on the policy

Interest earned on a life insurance policy is generally taxable. If your beneficiaries receive interest earnings from your policy, along with the death benefit, this interest can be taxed by the Canada Revenue Agency (CRA) as income.

The CRA does not consider the death benefit to be taxable income, and beneficiaries do not need to report the payout as additional income on their Canadian tax return. However, any interest earned on the policy is treated differently and is usually taxed.

The interest earned on the policy will be taxed as income, whereas the growth of the cash value while it is locked up in the policy is exempt from taxation.

If your beneficiaries receive interest, the insurance company will automatically issue a T5 slip, and this interest will need to be reported on line 12100 of that year's tax return.

It is important to note that the tax rules regarding life insurance can be complex and depend on factors such as the type of policy, the purpose of the insurance, and the tax laws in the specific province or territory. Consulting a qualified tax professional is always recommended if there are any questions or concerns about taxation on interest earned from a life insurance policy in Canada.

Withdrawing from a permanent policy

Withdrawing from a permanent life insurance policy in Canada is a complex process with several implications. Here are some key points to consider:

Withdrawing money from a permanent life insurance policy in Canada is possible, but it's important to understand the potential tax consequences and how it can affect your beneficiaries. Withdrawals are typically made from the cash value or investment component of the policy, which grows over time. This cash value is accessible through a few different methods:

• Withdrawal: You can withdraw a portion of the cash value, but this may result in a tax liability if the withdrawal exceeds the policy's adjusted cost basis (ACB). The ACB is usually around 75% of the policy's cash value. Withdrawals that are less than or equal to the total premiums paid are generally not taxable.
• Policy Loan: You can borrow against the cash value of your policy, which is like taking an advance on the death benefit. Policy loans that are equal to or less than the ACB are typically non-taxable. However, if the loan exceeds the ACB, it will be considered a taxable gain, and the insurance company will issue a T5 slip for tax reporting.
• Collateral Assignment: You can use the cash value of your policy as collateral for a loan from a third-party institution, such as a bank. The loan proceeds are usually received tax-free, and the loan can be structured as a line of credit. Upon your death, the proceeds from the life insurance policy are used to pay off the loan and any unpaid interest.

Implications for Beneficiaries

Withdrawing from a permanent life insurance policy will reduce the death benefit that your beneficiaries will receive. If you withdraw against the cash value, your beneficiaries will still receive the original death benefit amount, but they will not benefit from the growth. Additionally, any interest earnings that your beneficiaries receive from the policy may be taxed as income by the Canada Revenue Agency (CRA). Therefore, it is important to carefully consider the impact of withdrawals on the future financial security of your loved ones.

Tax Implications

The tax implications of withdrawing from a permanent life insurance policy depend on several factors. Firstly, if your withdrawal exceeds the total premiums you have paid into the policy, the excess amount may be considered taxable income. Secondly, if you cancel or surrender your policy to access the cash value, the amount received above the total premiums paid may be treated as a taxable gain. Finally, any interest or investment earnings on the policy may be subject to capital gains tax, and you will need to include a T5 slip with your tax return.

In summary, while it is possible to withdraw from a permanent life insurance policy in Canada, it is important to carefully consider the tax implications and how it will affect your beneficiaries. Withdrawals may result in a tax liability and reduce the death benefit for your loved ones. Consulting with a tax professional and a licensed financial advisor can help you navigate these complexities and make informed decisions.

Cancelling a permanent policy

Cancelling a permanent life insurance policy is also known as “surrendering” your policy or cashing it out. There are a few ways to go about this.

Surrender the policy for its net cash value

Whole life and universal life insurance policies include a savings component, which means a policy's cash value grows over time on a tax-deferred basis. Once your policy has been in force long enough, you can cash it out. However, you will receive the net cash value, not the actual cash value, as the provider will deduct any surrender fees. If you have had the policy for more than 15 years, the net cash value is likely to be very close to the actual cash value. Policies have a surrender period, during which the insurer will charge fees if you give up coverage. This is rarely more than 15 years.

Reduced paid-up insurance

If you no longer want to pay premiums but would like to retain some insurance protection, you can opt for reduced paid-up insurance. The insurer will cancel your existing policy and use its cash value to fund a new policy with a guaranteed death benefit. Since the new policy is paid up, you won't have to make any premium payments, but the payout will be lower. Not all insurers offer this option, so check with your provider.

Stop paying premiums

If you have a cash-value life plan and stop paying premiums, some providers will cash out the policy and end the coverage. Others will use the cash value to cover premium payments. When the cash value is exhausted, the coverage ends. If your policy had insufficient cash value to begin with, it will automatically lapse once the grace period for a premium payment ends.

When to cancel your permanent life insurance policy

A life insurance policy is a legally binding contract between you and the insurer, but you can cancel it at any time and for any reason. That said, it makes more sense to cancel at certain times. For example, if your dependents have become financially independent, you may no longer need coverage. Similarly, if you are getting a better rate elsewhere, it may be a good idea to cancel your existing policy.

Will you get money back when you cancel your policy?

Whether you will receive a refund depends on the type of policy and when you cancel it. Permanent life insurance policies might provide a cash payout upon cancellation, but surrender fees could reduce the amount. Term life insurance policies do not have a surrender value, so you will only receive a refund if you cancel during the free-look period or in the middle of a payment cycle.

Estate taxes

If you don't name a beneficiary in your life insurance policy, your estate will be designated as the beneficiary and your death benefits may be taxed. Here's what happens in this scenario:

• If you have a will, the life insurance payout will be added to the overall assets.
• These assets will then be divided between the people listed as the beneficiaries in that will.
• The money may be taxed once the estate is settled.

To avoid a tax payment when the executor of your estate files your final tax return, you should name a beneficiary in your policy. That way, your money goes exactly where you want it to go instead of to the Canada Revenue Agency (CRA).

In Canada, your death is considered intestate if you die without an official will. This triggers an expensive probate process that creates more stress for your loved ones and may leave them with less money due to costly probate fees and expenses to lenders and other financial institutions. When you die intestate, your estate automatically becomes the beneficiary of your life insurance policy, and the insurance proceeds are mixed with other assets in the estate. The province then distributes them according to a predetermined hierarchy, regardless of your wishes.

In Canada, the government doesn't impose estate taxes like in the US. Instead, your assets are subject to something called a deemed disposition, where your "investments are deemed to be sold at death". Any capital gains from this sale are added to a final income tax return submitted when you die. In Canada, half of your capital gains are considered taxable income, so this amount is added to your final tax return. However, the CRA defers the deemed disposition if your surviving spouse receives your assets through a rollover or trust. They will only pay taxes if they sell the assets.

Frequently asked questions