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 taxes on proceeds received from your policy?”
Generally speaking, there is not taxation on life insurance. However, in some cases, the life insurance payout could be taxed.
In this article, we take a look at these situations, and what you can do to avoid them.
Is Life Insurance Taxable?
Generally, life insurance benefits are not taxable. Death benefits paid directly to identified recipients are tax exempt, and the money does not need to be reported as supplementary income.
Most income gained from a life insurance policy is not subject to tax in Canada, but there are exceptions.
Upon your death, your life insurance company issues the death benefit to the beneficiary. Generally, there are two ways the insurance company payouts could be received — as a lump sum or in installments.
If your beneficiary decides to receive the death benefit in a single payment instead, they will not have to pay income tax on it. However, if they decide to receive the benefit in several payments (installments), there will be taxes on interest earned on the life insurance payout.
In short, when the beneficiary is one person or more, the death benefit itself is not taxable income. That is because in Canada, most inheritances and financial gifts are not regarded as income.
The proceeds of a life 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 life insurance policy or has a payout of $50,000 or $500,000, the payout will not be considered taxable income. 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 payout 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 cash 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 policy.
Additionally, you should name both primary and secondary beneficiaries on your life insurance policy. The secondary beneficiary receives the life insurance payout if the primary beneficiary passes away before the insured.
Lastly, to ensure the life insurance 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 some 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 life insurance policies.
Term life insurance policies do not include an investment component, but many permanent life insurance policies do. Some examples of permanent life insurance policy include whole life insurance and universal life insurance. 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 throughout your life. 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 permanent life insurance policy.
Your policy’s cash value is made up of two parts:
- The money that you paid in the form of life insurance policy premiums. This component, in life insurance parlance, is called the “policy basis”.
- The excess 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 life insurance 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 taxes on the above-basis amount — $5,000, that is.
To sum up, when you withdraw from your policy’s cash value, you pay taxes on the "above-basis" amounts. Your life insurer will tell you how much of a withdrawal is “above basis.”
When you surrender your life insurance 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 insurance company 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, there will be 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 taxes.
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 policy you had
- The cost at which you sell it
- The amount of money you paid in premiums
- Whether the life insurance plan had cash value
When your beneficiary chooses to receive the payout in installments
Your beneficiary can choose to receive the life insurance 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 payout goes to the deceased’s estate
If your estate receives the death benefit after your death, this cash 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 life insurance proceeds of your policy by naming them as beneficiaries and keeping these selections up-to-date.
How can I minimize the taxes on my life insurance policy?
There are a few things you can do to minimize the taxes on your policy.
One is to choose a policy with a death benefit that is not taxable.
Another is to choose a policy that is tax-deferred. Finally, you can consult with a tax advisor to see if there are any other strategies that could be used to minimize the taxes on your policy.
Is there anything else I need to know about life insurance and taxes?
There are some things to keep in mind when it comes to life insurance and taxes.
First, life insurance proceeds are generally not taxable. However, there are some exceptions to this rule, so it's important to consult with a tax advisor to be sure.
Secondly, if you have a life insurance policy that is paid for with after-tax dollars, the payout will be taxable to your beneficiaries.
How is life insurance taxed?
There are a few different ways that life insurance can be taxed. If the policy is purchased through an employer, the premiums are usually paid with pretax dollars, which means that the payout is not subject to tax.
If the policy is purchased on an individual basis, the life insurance premiums are usually paid with after-tax dollars, which means that the death benefit is subject to income tax. In either case, the death benefit is generally not subject to estate tax.
What are the tax consequences of cashing in a life insurance policy?
When you cash in a policy, you are essentially selling the policy back to the insurance company. The tax consequences of this transaction will depend on a few factors, including the type of policy you have, how long you have had the policy, and the amount of money you receive from the sale.
If you have a whole life policy, the cash value of the policy may be subject to income tax.
Do my spouse or children have to pay your taxes after you pass away?
Life insurance proceeds can be used to pay for taxes you owe after you pass away. Your taxes will need to be paid out of your policy before anything else. For example, any debts or taxes will be paid out of your policy before beneficiaries receive their benefits.
What tax implications are associated with a permanent life insurance policy?
A permanent life insurance policy serves as a long-term financial safeguard, with potential tax advantages. The cash surrender value, akin to a valuable asset, typically grows tax-deferred.
However, it's essential to be aware that withdrawals beyond the life insurance premiums may be subject to taxation. Understanding these implications is crucial in making informed decisions about your policy and ensuring your life insurance remains taxable-free.
Are life insurance premiums tax-deductible on my tax return?
Life insurance premiums, while not tax-deductible, play a pivotal role in securing your beneficiaries' financial future. The tax-free death benefit provides a safety net for your loved ones during challenging times.
While premiums don't offer immediate tax benefits, the life insurance payout ensures your family's well-being and keeps the life insurance premiums from becoming taxable.
Can I access funds through permanent life insurance policies without facing tax consequences?
Utilizing a policy loan from your permanent life insurance policy can offer financial flexibility.
The loan is generally not considered taxable income, providing a useful resource in times of need. However, it's crucial to manage the loan responsibly, as unpaid loans may reduce the death benefit received by your beneficiaries, impacting their financial security and making the life insurance policy taxable.
What are the tax implications of surrendering life insurance policies?
Surrendering a life insurance policy could have potential tax ramifications. The cash surrender value received upon cancellation might be subject to taxation if it exceeds the total life insurance premiums paid.
Seeking guidance from an insurance company professional or financial advisor is advisable before making such a decision to ensure life insurance policies remain non-taxable.
Do beneficiaries need to report the tax-free death benefit on their tax return?
Beneficiaries receive a tax-free death benefit, offering a valuable financial resource in difficult times. This benefit ensures that the amount received remains intact without any tax deductions.
Rest assured, your loved ones can rely on the full benefit amount to secure their financial future, keeping the life insurance taxable aspect at bay.
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.
If you have any questions regarding life insurance, please feel free to contact one of our Dundas Life employees who will be able to help you make the decision that is right for you.