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Most people know that life insurance proceeds are paid out tax-free.
But how about the cash value inside a policy? Can you also take that out without paying tax?
And in what situations can you deduct your premium from your income?
This post answers these questions and more, all the while simplifying life insurance taxation to make it easy to understand.
- Key takeaways:
- While your beneficiaries receive the death benefit tax-free, there are several taxable events within a life insurance policy, such as cash withdrawals or loans.
- The most tax-efficient method of using the cash value inside your policy is through a collateral loan.
- Life insurance premiums are deductible only in certain situations.
Is Life Insurance Taxable?
There are lots of transactions within a life insurance policy that can give rise to tax. No wonder people struggle with life insurance taxation! But don’t fret, we’ll break down each of them one by one to make it as painless as possible.
Are life insurance proceeds taxable?
Your beneficiaries receive the entire payout tax-free. For universal life insurance, that includes any cash value inside the policy. And for whole life insurance, that includes any extra insurance purchased by dividends.
Is the growth of the cash value taxable?
With permanent insurance policies like whole life and universal life, you can deposit funds above the cost of insurance. One of the major benefits of these types of insurance is that these funds grow tax-sheltered, so long as it’s within the government limits.
Like an RRSP and TFSA, there’s a limit on how much you can deposit into your insurance policy above the cost of insurance. That’s because the Canadian government doesn’t want you to have too much tax-free growth.
This limit is proportional to the amount of insurance you buy. Therefore, the higher your coverage, the more cash value you can shelter from tax.
Is a cash value withdrawal taxable?
One of the ways to get the cash out is to withdraw it. A withdrawal is considered a disposition and as a result, you may have to pay tax.
Anytime the cash value is greater than the adjusted cost base (ACB) of the policy, there is a policy gain and you have to report it on your tax return. Unlike a capital gain where only 50% is taxable, the entire policy gain is taxable. The insurance company will send you a T5 slip showing the taxable amount.
Taxable gain = Cash value – ACB
The ACB of the policy represents the cost amount of the policy and is calculated by:
ACB = Premiums – NCPI
The formula is more complex but these are the main components.
The net cost of pure insurance (NCPI) is a measure of the actual cost of insurance in any particular year. Whereas your premium can be level, your NCPI increases every year as your mortality rate goes up. Eventually, the NCPI will be higher than the premium.
The ACB of the policy starts out low, steadily increases, and then decreases as the NCPI rises. The cash value starts out low and climbs steadily. After they cross, you will have to start paying tax on withdrawals.
If you decide to cash in your life insurance policy during retirement, prepare to have a large taxable policy gain.
The graph below shows a 40-year-old male non-smoker buying $100,000 of whole life insurance for $2,103/year. At age 56, the cash value (red line) crosses the ACB (yellow line). This is when he needs to start paying tax on withdrawals.
The ACB increases until age 70 when NCPI (blue line) becomes greater than the premium (green line). Then it starts to decrease until it reaches 0 at age 88.
Is a policy loan taxable?
Besides a withdrawal, you can also access your cash value via a policy loan. With this method, if the loan exceeds the ACB, you have to report the difference as a taxable policy gain.
When you repay the loan, you can deduct the amount up to the previous policy gain from your income.
For example, if the ACB is $10,000 and the loan is $15,000, the $5,000 is a policy gain. When you repay the loan, you can deduct $5,000 from your income, and the ACB is restored to $10,000.
Is a collateral loan taxable?
The last method of accessing the cash value from your policy is also the most tax-efficient. It involves using the cash value as collateral for a loan from a bank.
Unlike a withdrawal or loan, a collateral loan is not considered a disposition. As a result, you don’t have to pay tax on the loan.
For both the policy loan and collateral loan, if you use it to generate business or property income, the interest may be tax-deductible.
Are whole life insurance dividends taxable?
You have a few options when it comes to dividends from a whole life insurance policy. You can:
- Take the dividend as cash
- Use it to buy more insurance
- Use it to pay for your premiums
If you take it as cash, the dividend will reduce your ACB. Once your ACB reaches zero, further dividend payments will result in taxable policy gains. You can avoid this by choosing one of the other options.
The second option is the most popular one and gives you the highest long-term cash values.
Is an ownership transfer taxable?
Whenever you transfer ownership of an insurance policy, it’s considered a disposition and you may have a taxable gain. This includes transfers into and out of your corporation. However, there are two exceptions where you can transfer the policy tax-free.
The first is when you transfer it to your spouse or common-law partner. The second is when you transfer it to your child where your child is the life insured under the policy.
In these two cases, you’re deemed to dispose of the policy at its ACB, resulting in no tax payable. The recipient is deemed to acquire the policy at its ACB as well, resulting in a tax-deferred transfer.
Is Life Insurance Tax Deductible?
In most use cases, you can’t deduct the premium that you pay from your income. This includes corporate-owned policies insuring the life of a key person. However, there are a few exceptions as shown below.
Collateral life insurance
If you use a life insurance policy as collateral for a loan to earn income, you can get a tax deduction. To qualify, you have to meet the following conditions:
- You must assign the policy to a lender.
- The lender must be a restricted financial institution (eg: a bank, credit union).
- The loan must be used to earn income from a property or business.
- The policy must be required as collateral for the loan.
After meeting all the criteria, the amount you can deduct is the lesser of:
- The annual premium, and
- The NCPI
Charitable donation
If you gift a life insurance policy to a charity, you receive a tax credit equal to the fair market value of the policy. You keep receiving tax credits as you continue paying the premiums.
For a corporation, instead of a tax credit, it will receive a tax deduction.
When are the premiums a taxable benefit?
The opposite of a tax deduction is a taxable benefit. Instead of reducing your income, a taxable benefit is added to your income, increasing the taxes you have to pay.
When does this happen? Fortunately, not very often. If you, as an employee, have an employer who pays your life insurance premium, it is a taxable benefit for you. However, it is also deductible for the employer.
CRA isn’t as generous if you’re a shareholder of the company. In this case, the premium paid by the employer is considered a shareholder benefit. The difference between a taxable benefit and a shareholder benefit is that the latter is NOT deductible by the corporation.
Shareholder benefits can also arise for corporate-owned policies where the beneficiary is not the corporation. For example, naming your spouse as the beneficiary of a corporate-owned policy results in a shareholder benefit and should be avoided at all costs. Instead, you should name the corporation as the beneficiary. After you pass away, your corporation gets the proceeds and receives a credit to its capital dividend account (CDA) using this formula:
CDA = Death benefit – ACB
The corporation then pays your estate a tax-free dividend from the CDA, and flows to your spouse from your estate. Since the ACB will be very low at life expectancy, you can pay the majority of the death benefit tax-free from your corporation to your estate.
Have Questions About Life Insurance Taxation?
Nothing in life is certain but death and taxes.
But when it comes to the taxation of life insurance, things are a bit more nuanced.
Although the payout of the life insurance proceeds is tax-free, lots of other transactions can give rise to a taxable event.
You’ll want to pay special attention if you have a permanent life insurance policy or a corporate-owned policy since these are associated with more complex tax situations.
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