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Life Insurance and Taxes: What You Need to Know

Mark Virgil Lofranco • 12 November 2024

Life insurance is often seen as a way to cover end-of-life expenses and provide financial support to your loved ones after you’re gone. But life insurance can also offer financial benefits while you’re still alive. To make the most of your policy, it’s important to understand how taxes factor into the equation.


Before we dive deeper, know that there are two main types of life insurance: term and permanent. When a death benefit is paid to a beneficiary under either policy type, it’s generally not taxable and doesn’t need to be reported on a tax return. The only exception arises when you cash in a permanent life insurance policy before your death, in which case taxes may be due on any gains from the policy’s investments.


Let’s explore how life insurance policies work, the tax implications, and how the CRA handles life insurance distributions.


What is Term Life Insurance?


Term life insurance offers coverage for a specified period, usually between 5 and 30 years in Canada. If you pass away during the term, your beneficiaries receive a death benefit. However, term life insurance has no cash value, and you don’t get reimbursed for premiums if you decide to end the policy before the term expires.

Many employees are familiar with group term life insurance, which is a policy paid for by employers. This type of policy pays benefits only in the case of death, disability, or similar circumstances.


Understanding Life Insurance Premiums


A premium is the amount you pay to maintain your life insurance coverage. Premiums are typically billed monthly and are based on factors like your age, health, and the type of policy you choose.

If your employer pays for your life insurance, it’s considered a taxable benefit. This means any premiums you pay for group life insurance (excluding group term or optional dependant life insurance) will be reported on your T4 slip and must be included in your tax return.


What is Permanent Life Insurance?


Permanent life insurance, unlike term life insurance, covers you for your entire lifetime. There are two main types: universal and whole life. Permanent life insurance includes an investment component that grows tax-free within the policy. Many people choose permanent life insurance to ensure their loved ones can cover end-of-life expenses, like funeral costs.


Are Life Insurance Distributions Following Death Taxed?


One of the major benefits of life insurance is that distributions paid to beneficiaries after your death are generally tax-free. This means that your beneficiaries won’t need to pay income tax on the money they receive, allowing them to use the full amount for your funeral or other needs.



How Can Life Insurance Reduce Taxes on My Final Return?

Instead of naming a person as the beneficiary of your life insurance policy, you can name your estate. This may help reduce taxes in several ways:

  • The CRA doesn’t impose inheritance taxes.
  • The person who inherits your estate won’t need to pay tax on it.
  • Your life insurance policy can be used to cover your final tax liabilities, ensuring your heirs receive more of your estate.

Keep in mind that the CRA requires your representative to file a final tax return on your behalf. They will calculate any capital gains on assets as if they were sold at the time of death. After taxes are settled, the remainder of your estate is passed on to your heirs according to your will.



How Do I Cash Out My Permanent Life Insurance Policy?


In some cases, you can access the value of your permanent life insurance policy before you die. This is known as taking a pre-death distribution. If you cash out part of your policy, you must report any taxable policy gains.


For tax purposes, a withdrawal is considered a surrender of part of your policy. To calculate the taxable gain, subtract the Adjusted Cost Base (ACB) from the cash surrender value (CSV). If your ACB is $0, the entire CSV will be taxable.


For example, if your cash surrender value is $27,000 and the ACB is $0, you would owe taxes on the full $27,000. However, unlike other investments, this gain isn’t considered a capital gain—it’s taxed as income.


Final Thoughts


Life insurance is more than just financial protection for your loved ones after you’re gone—it can also offer tax advantages and financial flexibility while you’re still living. Understanding how life insurance distributions are taxed can help you make informed decisions about your policy.


For Canadian residents, note that insurance companies don’t withhold tax on partial withdrawals, so it’s crucial to factor in any tax implications when accessing your policy’s value.


Key Takeaways

  • Life insurance death benefits paid to beneficiaries are typically non-taxable.
  • Permanent life insurance includes a tax-free investment component that builds over time.
  • If you take a pre-death distribution from a permanent life insurance policy, you may need to report taxable gains.

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