There’s more to life insurance than just helping with end-of-life expenses (such as your funeral) and relieving certain tax liabilities for your survivors. Life insurance can also have potential financial benefits while you’re still here. But knowing the tax implications is important.
What you should understand first is that there are two main types of life insurance policies: term and permanent. When you receive a death benefit under either policy type as a beneficiary, it’s almost always considered a non-taxable event and doesn’t need to be reported on your tax return.
The only exception is if you decide to cash in a permanent life insurance policy before your death and you receive the cash surrender value. In that case, you’ll have to pay taxes based how much your investments have increased in value.
Read on for more information about life insurance policies, tax-filing considerations, and how the Canada Revenue Agency (CRA) taxes life insurance distributions.
- When you receive a death benefit as a beneficiary under life insurance, it’s almost always considered a non-taxable event and doesn’t need to be reported on your tax return.
- Permanent life insurance has an investment component so you can build up your investments inside your insurance policy, tax-free.
- If you take a pre-death distribution from your permanent life policy, you must report any taxable policy gains.
What is term life insurance?
Just like it sounds, term life insurance provides coverage for the duration of a specific term. This is the period of time you are covered by the policy. Time periods you can choose in Canada typically range between 5 and 30 years. If you die during the term your policy is active, the beneficiaries you designate receive the death benefit. The policy itself has no cash value, and you can end it at any time. However, you do not get reimbursed for any premiums you have paid out.
Group term life insurance is probably familiar to you if you’re a salaried employee at a company. It’s a term life insurance policy as described above, but paid for by your employer. The only amounts payable by the insurer are policy dividends, experience rating refunds, and amounts payable on the death or disability of a current, former, or retired employee, or their covered dependants.
Understanding life insurance premiums
A life insurance premium is the rate you pay for your coverage—whether the policies are term or permanent. These payments, often billed monthly, are determined using factors like age, health, policy type, and coverage limits. Paying premiums on time also keeps your policy active.
When it comes to the tax side, if you have an employer-paid life insurance policy, it’s considered a taxable benefit. So any premiums you pay for group life insurance—not considered group term insurance or optional dependant life insurance—are taxable as well.
These amounts are included on your T4 slip and reported on your tax return as a taxable benefit.
What is permanent life insurance?
There are two variations on permanent life insurance: universal and whole-life. While term is only meant to last for a set period of time, permanent life insurance is meant to last throughout your entire lifetime.
Permanent is more than just a life insurance policy; it also has an investment component. You’re able to build up your investments inside your insurance policy, tax-free. A lot of people choose permanent life insurance to help their loved ones cover funeral costs when they die.
Are life insurance distributions following death taxed?
Having a life insurance policy has its benefits: a main one being that life insurance distributions following your death are not taxed. So, if a beneficiary receives a distribution from your life insurance plan upon your death, that person does not have to pay income tax on it.
You can request that the beneficiary use some of these tax-free funds to help cover your end-of-life expenses, such as your funeral, or you can allow the funds to be used however the beneficiary desires. But either way no taxes will be taken out, allowing for the full amount to be utilized.
How can life insurance reduce taxes on my final return?
Instead of naming someone as the beneficiary of your life insurance policy, you can name your estate as your beneficiary. This can help lower taxes in a few ways:
- 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 CRA 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.
How do I cash out my permanent life insurance policy?
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 any taxable policy gains.
For tax purposes, a withdrawal is a surrender (or partial surrender) of a policy and is considered a disposition. To calculate any taxable policy gains for a partial surrender, the proceeds of disposition (PD) is the amount withdrawn and the Adjusted Cost Base (ACB) of the policy is prorated based on the PD’s proportion of the entire cash surrender value.
For example, if the partial withdrawal from a policy is 25% of the cash surrender value, the ACB used in determining if there is a taxable policy gain is 25% of the ACB of the whole policy.
Here is an example: You paid $28,000 in premiums and the total cost of the “net cost of pure insurance” was $30,000. Now, rather than having an ACB of minus $2,000, the ACB is set at $0. The cash surrender value is $27,000. When you apply the taxable gain formula (CSV minus – ACB), the amount taxable is $27,000 minus $0. And you get $27,000. That amount is taxable, and it is not considered a capital gain.
For Canadian resident policy owners, the insurer does not withhold tax at the source on a partial withdrawal.
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