Tax Implications of Life Insurance

Life insurance can help with end-of-life expenses such as your funeral, and it can help relieve certain tax liabilities for your survivors. However, before purchasing life insurance, you should understand how the Canada Revenue Agency taxes its distributions.

Life insurance distributions following the death of someone else are not taxed.

• If a beneficiary receives a distribution from your life insurance plan upon your death, he does not have to pay income tax on it.
• You can request that the beneficiary use some these funds to help cover your end-of-life expenses, such as your funeral, or you can allow him to use the funds as he desires.

Instead of naming someone as the beneficiary of your life insurance account, you may name your estate as the beneficiary.

• The CRA does not charge inheritance taxes.
• Whoever inherits your estate does not have to pay tax on it.
• If you have a life insurance policy, you can ensure it is used to cover your final taxes so your heirs can inherit as much as possible.

However, the agency requires your representative to file a final tax return on your behalf. For the purposes of this return, it assumes you have disposed of all of your assets, and it assesses your capital gains tax as relevant. Once those taxes have been settled, the remainder of your estate passes to whomever you have named in your will.

In some cases, you can take distributions from your life insurance before you die.

Typically, you can only take pre-death distributions from permanent life insurance policies, and you must report some of the distribution as a capital gain. To calculate capital gains, you start with the proceeds of distribution and then subtract the Adjusted Cost Base (ACB) of the asset. In most cases, the ACB is the amount you paid for the asset.

Many people erroneously assume the ACB in this case is the amount you have paid for your premiums over the years. Some of your premiums are an expense directly related to the privilege of having life insurance, and as a result, they cannot be used to calculate your ACB. Instead, you need to take the amount of premiums paid minus the value of insurance to determine your ACB.

For example, imagine you have taken a $150,000 distribution (sometimes referred to as a cash surrender value) from your whole life policy, and over the years, you have paid $50,000 in premiums. According to the T5 slip issued by your insurance company, $10,000 of your premiums were simply related to the cost of being insured. As a result, you subtract $10,000 from $50,000 to find your ACB of $40,000. Subtract this amount from your distribution of $150,000 to arrive at your capital gain of $140,000.