Life insurance is essentially buying peace of mind. You are making sure your loved ones will be provided for financially if you die before you expect to. The money can support your family in your absence, such as paying off the home loan and taking care of your child’s education.
Naturally, when you think about purchasing life insurance, you might also wonder: “Is life insurance taxable? Will your beneficiaries have to pay tax on proceeds received from your policy?”
Generally speaking, life insurance is not taxable. However, in certain situations, the payout could be taxed.
In this post, we take a look at these situations, and what you can do to avoid them.
Is Life Insurance Taxable?
Most income gained from a life insurance policy is not subject to income tax in Canada, but there are exceptions.
Upon your death, the provider issues the death benefit to the beneficiary. Generally, there are two ways the payout can be received — as a lump sum or in installments.
If your beneficiary decides to receive the death benefit in a single payment, they will not have to pay income tax on it. However, if they decide to receive the benefit in installments, they will be required to pay tax on interest earned on the death benefit.
In short, when the beneficiary is one or more individual, the death benefit itself is not taxable. That is because in Canada, most inheritances and financial gifts are not regarded as income. The proceeds of an insurance policy come under this category. Consequently, your beneficiaries will not be required to report the payout on their tax return.
This is true regardless of the type of the policy you have or its size. Whether your policy is a term or a permanent policy or has a death benefit of $50,000 or $500,000, the payout will not be considered taxable. However, if your beneficiary earns interest on the death benefit, that income will be subject to tax.
But what happens when the estate is named as the beneficiary?
This is where things get a little complicated. When the death benefit is paid to the deceased’s estate, it can become taxable along with the rest of the estate.
Keep in mind that your estate may also receive the death benefit even if you have not named it as a beneficiary. This can happen when:
- you have not named anyone as the beneficiary
- the beneficiary dies before you
Any money or assets belonging to your estate are first used to pay off the estate taxes, debts owed by you, and other expenses (like legal, executor, and accounting fees) before they can be distributed among your heirs. For this reason, financial experts do not recommend naming the estate as a beneficiary on a life insurance policy.
Additionally, you should name both primary and secondary beneficiaries on your policy. The secondary beneficiary receives the payout if the primary beneficiary passes away before the insured. Lastly, to ensure the proceeds of your policy do not go to your estate, keep your beneficiaries up-to-date.
Are there situations where life insurance is taxable?
There are certain situations when life insurance can be taxable. These are:
When you withdraw funds from your cash-value life insurance
Life insurance policies come in two types — term and permanent. Term policies do not include an investment component, but many permanent plans do. This inbuilt investment component is called cash value, and the money in this account grows on a tax-deferred basis.
The cash value is for you to use during your lifetime. Your beneficiaries receive only the death benefit upon your death, not the cash value. You can tap into your policy’s cash value through a loan or withdrawal or by surrendering the policy.
Your policy’s cash value is made up of two parts:
- The money that you paid in the form of policy premiums. This component, in life insurance parlance, is called the “policy basis”.
- The money gained from interest. This component is referred to as the “above basis” and is subject to tax.
For instance, let’s say your policy has $30,000 in the cash value account. If you paid $25,000 in premiums, you have a policy basis of $25,000 and an above basis of $5,000. If you withdraw all of this money, you will have to pay income tax on the above-basis amount — $5,000, that is.
To sum up, when you withdraw from your policy’s cash value, you pay tax on the amount that is “above basis.” Your life insurer will tell you how much of a withdrawal is “above basis.”
When you surrender your policy
It is possible that you no longer need the protection offered by life insurance. Maybe your kids have become financially independent. Or perhaps you have saved enough to allow your spouse to live comfortably even if you are no longer around.
Upon receiving your request, the life insurer will terminate the coverage and issue you the surrendered cash value. Your policy’s surrendered cash value is equal to your cash value minus any deductibles (like surrender fee and other charges).
As in a withdrawal, you will have to pay tax on the above-basis part of your surrender cash value.
When you take out a policy loan and the coverage ends
One way of accessing the cash value is by taking out a loan against it. The amount you borrow is not taxable, as long as the policy is active. If your policy ends before the loan has been paid off, you will have to pay tax.
However, you will not be taxed on the entire amount you borrowed. You will have to pay tax on only that part of the loan that is “above basis”.
When you sell the policy
In Canada, four provinces allow you to sell your life insurance policy. These are Quebec, Nova Scotia, New Brunswick, and Saskatchewan. If you reside in these provinces, you can legally sell your policy. But remember that you could get taxed on the money you make.
How much tax you will pay depends on many factors, such as:
- The type of life insurance policy you had
- The selling price
- The amount of money you paid in premiums
- Whether the life insurance policy had cash value
When your beneficiary chooses to receive the payout in installments
Your beneficiary can choose to receive the proceeds of your policy in a lump sum or in installments. If they select the latter method, they could face a tax bill. Any interest earned on the death benefit amount is subject to income tax.
When the death benefit goes to the deceased’s estate
If your estate receives the death benefit after your death, this money could be subject to tax.
What about beneficiaries?
Life insurance, like investments and funeral plans, is an important part of an estate plan. A proper estate plan, in turn, can offer emotional as well as financial relief for your family. You can ensure your loved will not need to pay tax on the proceeds of your policy by naming them as beneficiaries and keeping these selections up-to-date.
Nobody wants to pay more in taxes. So, it is natural to be worried about whether you and your beneficiaries could get taxed on your life insurance policy. Thankfully, life insurance payouts generally are not taxable. You can set up a financial safety net for your loved ones without worrying about them receiving less money than your policy’s face value. `