Whole Life Insurance: Taxable In Canada?

Life insurance is a contract between an insurer and a policyholder, where the insurer promises to pay a lump sum to the beneficiary upon the death of the insured. While the death benefit is typically tax-free, there are several tax implications to consider when it comes to life insurance in Canada. In general, life insurance premiums and contributions are not tax-deductible, and the death benefit paid to the beneficiary is not considered taxable income. However, the cash values and investment earnings of permanent life insurance policies are subject to taxation. This means that if you withdraw or cancel your permanent life insurance policy, you may be taxed on any cash value that has built up. It's important to understand the tax rules and regulations related to life insurance in your country to avoid unexpected tax liabilities and make informed financial decisions.

Naming your beneficiaries

Understanding Beneficiaries

Firstly, a beneficiary is the person or entity that will receive the death benefit from your whole life insurance policy in the event of your passing. It is essential to appoint a beneficiary to simplify the settlement process, eliminate potential taxes, and ensure your wishes are carried out.

You can name multiple beneficiaries and specify the percentage of the death benefit each will receive. This allows you to include loved ones, such as your spouse and children, as well as charitable organizations or non-family members.

There are two types of beneficiaries: primary and contingent. Primary beneficiaries are the first in line to receive the death benefit. However, they must be alive at the time of your death to receive the payout. Contingent beneficiaries, also known as secondary beneficiaries, will receive the benefit if the primary beneficiaries are no longer alive.

Tips for Naming Beneficiaries

• Keep your beneficiaries informed: Let your beneficiaries know that they have been named and provide them with the necessary details.
• Be specific: Clearly specify the names of your beneficiaries, including legal names and, if applicable, social security numbers. If naming a charitable organization, include their name, address, and tax ID number.
• Name secondary beneficiaries: It is essential to name contingent beneficiaries to ensure that your death benefit will always go to the intended recipients and remain tax-free.
• Review and update: Life changes, such as marriage, divorce, the birth of a child, or a change in financial circumstances, may require you to update your beneficiaries. Regularly review your policy and make amendments as needed.
• Consider a trust for minor beneficiaries: If you name a beneficiary who is under the age of majority, consider setting up a trust and designating a trustee or administrator to manage the funds on their behalf until they reach the legal age.

Tax Implications

The tax implications of whole life insurance policies can be complex, and it's always recommended to consult with a qualified tax professional for personalized advice. However, here are some key points to consider:

• Tax-free death benefit: In most cases, the death benefit paid to your beneficiaries is tax-free and does not need to be reported as taxable income in Canada.
• Interest earnings: If your beneficiaries receive interest earnings from your policy, this interest may be taxed as income by the Canada Revenue Agency (CRA).
• No tax on permanent policy withdrawals: Withdrawing against the cash value of your permanent life insurance policy is generally not taxable, as long as it does not exceed the total premiums paid into the policy.
• Tax implications on policy loans: Taking out a policy loan, where you borrow from the insurance company secured by the cash value of the policy, has different tax consequences. Policy loans up to the Adjusted Cost Basis (ACB) of the policy are typically non-taxable, but loans exceeding the ACB may be subject to tax.
• Avoid estate taxes: If you do not name a beneficiary, your estate becomes the default beneficiary, and the death benefit may be subject to estate taxes.

Remember, it is crucial to seek professional advice from a licensed insurance advisor or tax accountant to ensure you understand the tax implications of your whole life insurance policy and make the most tax-efficient decisions.

Interest or dividends on policies

Interest or dividends earned on a life insurance payout will be taxed. This is separate from the death benefit, which is tax-free. The interest earned will be taxed as income by the Canada Revenue Agency (CRA).

If you are the beneficiary of a life insurance policy, you will not have to pay taxes on the death benefit. However, if you receive interest or dividends on the policy, this will be taxed as income. This is because the interest is considered an investment income, and investment income is taxable.

The insurance company will send you a T5 tax slip, which details the investment income you will need to report to the government. You will need to report this on line 12100 of that year's tax return.

It is important to note that if you are the owner of the life insurance policy and the beneficiary, the proceeds may be subject to tax. This can happen if you own a policy and your parents are the insured, and you are also the beneficiary.

Cash withdrawals

Withdrawing cash from a permanent life insurance policy can have tax implications because the policy has accumulated a cash value that grows over time. This cash value is often invested to increase the policy's worth, and any investment gains are generally not taxed while they are accumulating. However, when a policyholder withdraws cash from the policy, the withdrawal may be subject to taxation.

The taxation of cash withdrawals depends on the amount withdrawn relative to the total premiums paid into the policy. Withdrawals up to the total amount of premiums paid are typically considered a tax-free return of capital. However, any withdrawal amount that exceeds the total premiums paid is generally considered taxable income. The taxable portion of the withdrawal is then subject to the policyholder's marginal tax rate.

It is important to note that withdrawing cash from a permanent life insurance policy can also affect the policy's death benefit. Withdrawals may reduce the policy's cash value, which could ultimately reduce the death benefit paid out to the policy's beneficiaries.

In summary, cash withdrawals from a permanent life insurance policy in Canada may be taxed, depending on the amount withdrawn and the specifics of the policy. Policyholders should be aware of the potential tax implications and consult with a financial advisor before making any withdrawals that could impact their life insurance policy's tax status and death benefit.

Estate transfers

There may be probate fees, estate administration taxes, and estate settlement costs like executor, legal, and accounting fees that would need to be paid out in addition to any debts or taxes owed by the estate before any money or assets can be distributed to beneficiaries under the deceased's will. If no will was created, each province outlines who gets the assets, how much each person gets, and in what order. When there is no will for someone who has died, this is called "dying intestate."

Life insurance proceeds on death can also be used to pay for income taxes owed by the deceased and their estate on earned income, investment income, including capital gains, registered retirement savings plans (RRSPs) if a spouse has not been named as the sole beneficiary, and registered retirement income funds (RRIFs) if a spouse has not been named as either the sole beneficiary or successor owner.

Life insurance can also provide lump sums of cash and income to replace the income lost by the death of the life insured. Using investments for these purposes may mean selling them when the markets are down and losing opportunities for market rallies and increased values. Selling investments may trigger unrealized capital gains that must be reported and paid to the government before any distributions to beneficiaries.

Lending institutions such as banks, trust companies, and credit unions may require insurance as additional collateral on loans in case the borrower passes away before they are fully paid back. If there is an outstanding amount, the lender will subtract the loan amount from the total proceeds on the death of the life insured. The borrower's estate or named beneficiaries get the balance. Life insurance as collateral may be for up to a certain percentage of its cash value and/or its sum insured (the amount paid on the death of the life insured).

Selling your policy

Selling your life insurance policy in Canada is possible but highly limited. Whether you can sell your policy will depend on your age and health, where you live, and your life insurance company.

Selling a life insurance policy makes the most sense for someone who can no longer afford to pay their premiums or who has cash flow problems.

If you can't sell your life insurance policy, you can let it lapse, transfer it, or negotiate rates with your insurance company.

You can sell your life insurance policy in Canada, but only in some regions. For example, New Brunswick and Nova Scotia recently rescinded the ability to sell a life insurance policy. In contrast, in Ontario, a private member's bill is pushing to open life insurance to the secondary market.

Still, whether you can sell your life insurance policy in a legal state will depend on the conditions of your policy and your insurance company.

Selling a life insurance policy may seem counterintuitive, but there are many reasons why someone might do so:

• They can no longer afford the premiums. Seniors lacking retirement funds may struggle to pay their insurance premiums and benefit more from selling them.
• They need the cash. Someone experiencing cash flow problems may need to sell their life insurance policy to access its cash component.

Third parties, like other insurance companies, might buy your life insurance policy as an investment. You can also sell your policy to another individual, such as a child, business partner, or friend. Ultimately, you can sell your policy to virtually anyone, given that both parties have written consent.

If you have term life insurance with a convertibility option, you must first undergo this process to sell it. If your policy doesn’t have a conversion rider, you can’t sell it.

Death benefits on life insurance policies aren’t taxed, but sales on life settlements are. When you sell your life insurance policy, you’ll owe income tax for the amount you receive.

Finding a life insurance policy buyer is difficult – you can’t just list it online and wait for a bid. Hiring a broker can make the scouting process more accessible, but it takes time to compare rates. Some brokers charge commission rates as high as 40%, while others charge as low as 10%.

You must complete an application for each life insurance settlement and grant the settlement company or third party permission to request information about your policy and health.

Once you’ve completed the application process, gather the appropriate documentation, such as medical records from your healthcare provider. Age and health play a significant role in determining how easy it will be to sell your policy. Younger, healthier people often get lower returns, whereas older people (often above 65) have better chances of selling their policies.

You can’t just sell your life insurance policy for your desired sum. Underwriters will determine your policy’s market value and decide whether the investment is good or bad. They might consult medical experts regarding your health and seek any signs of fraud.

Assuming the underwriters determine your policy is suitable for purchase, they’ll extend an offer, which you can accept or decline.

Selling your life insurance policy may not be the most cost-effective option, even if you need the money. Remember, hiring a broker will also cost you. Here are some less complicated options you might consider:

• Cancelling the policy: If your policy is new and you can let it lapse.
• Using the accelerated benefit rider: If you become diagnosed with a terminal illness (you can access between 25% and 95% of the entire sum).
• Requesting to reduce the coverage amount: If you have a lenient insurance company that may understand your circumstances.
• Transferring your policy: If selling a life insurance policy is legal in your state and you can transfer it to a relative, such as a spouse, parent, or child.
• Getting a policy loan: If you have a whole life insurance policy that allows you to access the death benefit amount through a policy loan.

Frequently asked questions