Life insurance is essentially buying peace of mind. You’re helping your loved ones deal with the financial impact of your death and hopefully mitigating some of the accompanying stress and emotional turmoil. But what happens after your loved ones receive their inheritance? Is life insurance taxable in Canada? Is the payout you’re leaving behind subject to income tax? The last thing you want to do is leave your loved ones with more confusion—that’s why you purchased the policy in the first place. Here’s what you need to know about life insurance and the tax implications it could have.
Is life insurance taxable in Canada?
Most of the money received from a life insurance policy is not subject to income tax. The death benefit paid from a life insurance policy is a tax-free, lump-sum amount for the beneficiary that can be used to finance a number of things. This includes paying off debts, including a mortgage, so your family can remain in the same home and community. It can also be used to replace income, so your family can maintain their standard of living without you. It can pay for funeral expenses and preserve other assets, so they won’t have to be sold or liquidated. Additionally, it can provide for your children and dependents, or you may elect to give to a charity of your or your beneficiaries’ choosing. Your spouse, child or anyone else you’ve named as a beneficiary would not have to report life insurance proceeds as taxable income on their Canadian tax return. It doesn’t matter whether the life insurance policy was term insurance or whole insurance, or how big the policy was.
Now, we said “most” of the money isn’t taxable for the beneficiaries. So, what is? How complicated is it?
If the estate is named as the beneficiary, or if the beneficiary predeceases the life insured and no other (contingent) beneficiary has been named, then the proceeds on death of the life insured are paid to the deceased’s estate. This is where things get tricky: “There may be probate fees, estate administration taxes and estate settlement costs like executor, legal and accounting fees that would need to be paid out in addition to any debts or taxes owed by the estate before any money or assets can be distributed to beneficiaries under the deceased’s will,” says Peter Wouters, director of tax, retirement and estate planning services at Empire Life Insurance Company in Kingston, Ont. He adds that if no will was created, each province outlines who gets the assets, how much each person gets, and in what order. When there is no will for someone who died, that’s called “dying intestate.”
How to make your life insurance more efficient for beneficiaries
Life insurance, funeral plans and investments are all important parts of a proper estate plan, which can provide emotional and financial relief for your loved ones. How do things like a life insurance policy, funeral planning and investments play a role for said beneficiaries? How can you make taxes less of an impact on them?
First, the most important thing to do: File the names of your beneficiaries with the insurance company. “This may avoid probate and associated costs, as well as most outstanding debts owed by the deceased life insured,” says Wouters. “There are exceptions, like dependents relief, where the deceased had an obligation to provide for dependents, particularly under a separation or divorce agreement.” Naming beneficiaries on a life insurance policy may also speed up the settlement process, getting funds into the hands of beneficiaries faster and with privacy, since these payouts, unlike a will, do not form part of the public record. The more you prepare, the better it is for your loved ones.
“Life insurance proceeds on death can also be used to pay for income taxes owed by the deceased and their estate on earned income; investment income, including capital gains; registered retirement savings plans [RRSPs] if a spouse has not been named as the sole beneficiary; and registered retirement income funds [RRIFs] if a spouse has not been named as either the sole beneficiary or successor owner,” says Wouters. “Life insurance can also provide lump sums of cash and income to replace the income lost by the death of the life insured. Using investments for these purposes may mean selling them when the markets are down and losing opportunities for market rallies and increased values. Selling investments may trigger unrealized capital gains that must be reported and paid to the government before any distributions to beneficiaries.”
Lending institutions such as banks, trust companies and credit unions may require insurance as additional collateral on loans, in case the borrower passes away before it’s fully paid back. “If there is an outstanding amount, the lender will subtract the loan amount from the total proceeds on the death of the life insured,” says Wouters. “The borrower’s estate or named beneficiaries get the balance. Life insurance as collateral may be for up to a certain percentage of its cash value and/or its sum insured [the amount paid on the death of the life insured].”
More on how taxes work with life insurance in Canada
Here are some common questions about taxes and life insurance:
Can I claim life insurance on my income tax?
No. “Life insurance premiums—what you pay for the coverage—is generally paid with after-tax dollars. The payor then cannot normally deduct the cost,” says Wouters.
Will my spouse/children pay my taxes after I die?
Your taxes will need to be paid out of your policy, first and foremost. “Life insurance proceeds may be used to pay for taxes owed by the deceased,” says Wouters. “Debts and taxes have to be paid before distributions may be made to heirs from an estate.” He adds that life insurance can speed up the process of distribution of assets from the estate.
Do I pay tax on a life insurance policy–like whole life insurance–when it accumulates value?
It depends. “Growth is tax-sheltered up to certain limits set in the policy and according to legislation—as long as that growth is not taken out of the policy,” says Wouters. “The accumulated value is paid out as part of the tax-free death benefit when the life insured passes away.”
But is it taxable if you decide to cash it out? That’s up for the insurance company to figure out. The insurance company calculates what is reportable as taxable income, says Wouters. “If so, they send out a tax slip to the policy owner.” (That’s called a T5; more on that below.) If you wish to cancel or surrender your life insurance policy, you can let your financial advisor or the insurer know by calling or writing a letter. The provider may also require you to fill out a cancellation form. It may be a similar process for withdrawing or borrowing cash from your policy, but you need to keep paying premiums to keep your coverage in force.
Do I count earned interest and added value on my life insurance as income?
Again, not while it remains within the policy. “Any growth in the accumulated value or cash value of a permanent life insurance policy is not reportable income,” says Wouters. “The amounts invested after paying for the cost of pure insurance and administrative fees grow on a tax-sheltered basis.” Because the accumulation of cash values in life insurance is exempt from taxation, almost all policies sold in Canada are called exempt life insurance policies.
Do I pay taxes on an invested insurance payout and the accumulated interest?
Yes, when you get the payout. “Earnings on the payout of life insurance are subject to income tax on earned interest, dividends and realized capital gains on those invested monies, unless they’re invested into another tax-sheltered plan such as a tax-free savings account,” says Wouters. The insurance company handles investment decisions beyond the costs needed to provide pure coverage and administrative fees for permanent life insurance policies (except perhaps in the case of universal life). “The policy may have growing guaranteed cash values and additional non-guaranteed cash values that depend on factors including claims experience, operational costs, long-term interest rates and investment performance,” says Wouters.
What’s a T5?
A T5 is a tax-reporting slip that details various types of investment income; a Canadian resident must, in turn, report this income on their income tax and benefit forms. As mentioned above, life insurance proceeds paid out on the death of the life insured generally do not generate a tax slip and are not reported on a tax return. But if you do cash out a policy, you may receive a tax slip.
“A T5 form is used by the insurance company to report earnings from a life insurance policy, triggered by the policy owner borrowing or withdrawing money from the policy,” says Wouters. It identifies what type of investment income and how much investment income of each type must be reported by the taxpayer. “If the taxpayer has dividend income, the T5 slip shows how much taxable income they must report and how much of a tax credit they can apply for to reduce the taxes on that income. Each field in the form has a number that identifies where the taxpayer needs to report that income on their tax return.”
What is line 12100?
Line 12100 (known as line 121 up until the 2019 tax year) is the line where a taxpayer reports the earnings on certain life insurance policies that is shown on the T5 slip issued by the insurance company.
How is it used? Wouters explains: “The reported earnings on certain life insurance policies—most often coming from a direct policy loan, withdrawal or surrender of a permanent life insurance policy that has an accumulated value—is treated like other investment income. It’s ordinary income—not capital gains—and is fully taxable. It increases both gross income and net income on a recipient individual’s tax return.” The amount that needs to be reported is shown on the T5 slip issued by the insurance company.
When do I pay tax on life insurance?
Tax can be payable on the full or partial surrender of permanent life insurance that has a cash value, says Wouters. “You might also have to pay taxes if you borrow directly from the life insurance policy, and the amount that you borrow exceeds a certain amount called the adjusted cost basis of the policy. The longer you own a policy, the higher the cash value will be and, over time, the lower the adjusted cost basis will be.” The excess of the cash value over the adjusted cost basis is taxable when borrowed or withdrawn from the policy.
Wouters adds that the life insurance illustration (your insurance documents) you used to help with your buying decision, as well as a calculation from the insurance company, can tell you if the amount you withdraw or borrow at any time is subject to tax. If it is, then the insurance company will issue a T5, showing how much you need to report.