Life Insurance and Taxes [Complete Canadian Guide]

Life insurance is a lot like homeowner’s insurance. You hope that you’ll never have to use it, but if the unthinkable happens, you can rest assured that your loved ones will be protected financially. There are a lot of benefits to having life insurance and it is one of the best ways to secure your family’s future financial freedom. An important thing to consider for someone who has life insurance or is interested in life insurance, is taxes. Whether you are a young professional starting your financial journey or a seasoned investor looking to protect and grow your wealth, this life insurance and taxes guide will answer all the questions you have about life insurance and taxes.

In this article:

• Tax Benefits of Life Insurance
• Possible tax consequences of life insurance
• Is life insurance taxable in Canada?
• Are life insurance premiums tax-deductible in Canada?
• Is there sales tax on life insurance premiums in Canada?
• What is the exempt test?
• Life insurance as a tax shelter in Canada
• What are the tax consequences of cashing out life insurance?
• Getting life insurance loans tax-free
• When do I need to pay taxes on Life Insurance?
• Frequently Asked Questions (FAQs) about life insurance and taxes

Tax Benefits of Life Insurance

Possible tax consequences of life insurance

Is life insurance taxable in Canada?

In general, death benefits are tax-free in Canada because:

• They are not subject to probate (provided there is a named beneficiary)
• They are not part of your estate, so they stay off the public record

Although there is no death or inheritance tax in Canada, there are some considerations you should be aware of.

Personally-owned policies

Adult Beneficiaries: When personally-owned policies have adult beneficiaries, the full face amount is paid out tax-free shortly after the insurer receives the required documents.

Child Beneficiaries: If the beneficiary is a child, the tax-free proceeds are held in trust until they turn 18. A named trustee manages the funds according to a court-approved plan.

Charitable Beneficiaries: Registered charities receive life insurance proceeds tax-free, issuing a tax receipt to the estate and potentially reducing its tax liability.

Importance of Designating a Beneficiary: Appointing a beneficiary is crucial to avoid estate administrative tax and potential claims by creditors on the death benefit.

Corporately-owned policies

The payout from corporate-owned life insurance policies is tax-free but subject to different rules and processes. They must name the corporation as the sole beneficiary and corporate-owned policies with a personal beneficiary could be subject to a taxable benefit to the shareholder and/or the insured. 

When the corporation is both owner and beneficiary, upon the death of the insured it will receive a credit to a special notional tax account called the Capital Dividend Account (CDA). 

This credit requires the calculation of the policy’s Adjusted Cost Basis (ACB), which is the aggregate premiums for all years minus cumulative net cost of pure insurance (NCPI). Over time, the ACB will eventually decline to zero but depending on policy type and age, it can take years to reach this point.

The CDA credit is calculated as follows:

CDA Credit = death benefit minus ACB

Although the corporation receives the death benefit tax-free, the ACB ultimately determines how much of the proceeds are received by the shareholder(s) in the form of a non-taxable dividend. If you die before the ACB is reduced to zero, the proceeds of the life insurance exceeding the ACB would be paid out via a non-taxable dividend through a credit to the CDA.

On January 1, 2017, the Canadian government implemented significant tax changes that impacted new life insurance policies. Perhaps the most consequential adjustment was the amendments made to the NCPI factors, such as updated mortality tables.

In general, these changes resulted in a lower NCPI, which in turn created a higher ACB for a longer period of time. As noted previously, ACB is instrumental in determining how much can be paid out tax-free.

Are life insurance premiums tax-deductible in Canada?

Clients often ask us if life insurance premiums are tax-deductible. The answer is that it depends. For the most part, premiums are not tax-deductible for individuals or corporations – this means that you cannot claim a deduction for the premiums paid on your personal life insurance policy when filing your tax return. However, under certain circumstances, it may be possible.

Personally-paid policies

Collateral for a Loan: If a personally-paid and owned life insurance policy is used as collateral for a loan, the premiums may qualify for a tax deduction.

Policies Owned by a Charity: Premiums paid on personally-owned policies with a charity as the owner qualifies for a tax credit in the tax year they were paid. However, if the charity is the beneficiary, the tax credit is received by the estate upon the policyholder’s passing.

Corporately-paid policies

Premiums on Corporately-Owned Policies (Non-Deductibility): Premiums on a corporately-owned policy where the corporation is the beneficiary are not tax-deductible. This includes a key man life insurance policy.

Key Man Life Insurance and Tax Deductions: The Canada Revenue Agency (CRA) does not provide a key man life insurance tax deduction, as the business will receive the death benefit. However, similar to personal policies, a corporation may qualify for a tax credit if the life insurance policy is utilized as collateral for a business loan.

Deductibility of Corporate-Paid Life Insurance Policies: If you possess a life insurance policy that is paid by the corporation, it may qualify for a deduction if the premiums are deemed reasonable business expenses. An example would be when your company covers the premiums for your employees. Furthermore, policies owned by a charity with premiums paid by a corporation also qualify for a tax deduction.

General Rule for Insurance Premiums: In general, life, health, and disability insurance premiums are not tax-deductible for individuals or corporations. However, there may be exceptions to this rule based on specific circumstances. Consulting a tax professional can provide clarity on whether your situation qualifies for an exception.

Is there sales tax on life insurance premiums in Canada?

For the most part, there is no sales tax on Canadian life insurance premiums, which means that they are not subject to either the Harmonized Sales Tax (HST) or Provincial Sales Tax (PST). 

For a while, Saskatchewan was an exception to the rule. In 2017, the province levied a sales tax on all life insurance premiums, but in February 2018, this decision was reversed retroactively to August 1, 2017.

What is the exempt test?

The exempt test determines whether the earnings associated with a permanent life insurance policy’s cash value are taxable.

The Income Tax Act does not allow policies meant primarily for investment instead of protection. For a life insurance policy to accumulate tax-sheltered growth and retain its exempt status, it must pass an annual test administered by the insurance company. 

This test confirms that the policy’s cash value is staying below the MTAR line (also known as the Maximum Tax Actuarial Reserve), which establishes the maximum cash value the policy can have without losing its exempt status.

Life insurance as a tax shelter in Canada

Cash value life insurance policies (including universal life and whole life) have significant tax advantages.

Personally-owned policies

Permanent policies have a cash value that grows tax sheltered. As investment vehicles, they present an alternative to accounts such as:

• Registered Retirement Savings Plans (RRSP)
• Tax Free Savings Accounts (TFSA)
• Registered Education Savings Plans (RESP) 

While universal life policies let you select the underlying investment, whole life policies are a passive investment handled by the fund managers of the policy’s cash component. The account value of these policies remains tax sheltered.

Corporately-owned policies

Unlike personally-owned investment accounts, any passive income that the corporation earns is subject to a substantial tax liability. There are also no options like RRSPs and TFSAs. 

Preservation of Federal Small Business Deduction (SBD): Growth within corporately-owned permanent life insurance policies does not diminish the federal small business deduction (SBD). This deduction is significant for reducing the taxable income of small businesses.

Protection from SBD Elimination: Recent federal tax changes have resulted in the complete elimination of the SBD for corporations earning over $50,000 of investment income. However, the growth of assets inside corporately-owned policies remains unaffected by this elimination

What are the tax consequences of cashing out life insurance? 

While permanent life insurance offers tax benefits like tax sheltered growth, there is potential tax liability when you cash out the policy’s account value (fully or partially) or surrender the policy itself.

Personally-owned policies

Adjusted Cost Basis (ACB): When you partially or fully surrender a personally-owned life insurance policy, the ACB plays a significant role in determining your potential tax liability. Any amount withdrawn above the policy’s ACB is subject to taxation.

Tax-Free Withdrawals: If the withdrawal amount is equal to or less than the ACB of the policy, it can be withdrawn tax-free. In your example, if the ACB of your whole life insurance policy is $25,000 and you withdraw up to that amount, it would not be subject to income tax.

Taxable Withdrawals: If the withdrawal amount exceeds the ACB, the excess amount is considered taxable income. In your example, if you were to withdraw $75,000 (above the ACB of $25,000), the remaining $75,000 would be taxable.

Corporately-owned policies

Like personal policies, any withdrawal from a corporately-owned permanent life insurance policy is subject to tax above the ACB threshold. Any tax owing would be based on appropriate corporate tax rates.

Getting life insurance loans tax-free

While in some cases you may need to fully or partially surrender a whole life or universal insurance policy, there are other ways you can access the cash value, possibly tax-free.

Option 1 – Policy loan – Personally-owned

With a policy loan provided by your insurer, you can access the life insurance cash value without impacting the growth inside the policy. However, there are consequences you should consider first.

• You would be advancing against the cash value already built-up, which normally requires interest payments.
• ACB is a key factor because the loan is considered an advance on your benefit. The loan would be advanced against the ACB value tax-free, but anything beyond this threshold would be considered regular income and taxed accordingly. 

For example: you have a cash value of $75,000, an ACB of $35,000, and take out a policy loan for $50,000. The first $35,000 would be received tax-free while the remaining $15,000 would be taxed as regular income. However, if you repay the loan, you would receive a tax credit for the taxable portion received as income when the loan was first advanced.

Option 1 – Policy loan – Corporately-owned

Similar to a personal loan, a policy loan is considered an advance on your benefit and any amount exceeding the ACB would be taxable to the corporation. Interest on the loan may be tax-deductible to the business, provided the proceeds are used to earn income from a business or property.

Option 2 – Collateral loan or line of credit – Personally-owned

A collateral loan or line of credit gives you the option to borrow against the cash surrender value (CSV) of your insurance policy through a third-party lender. With the policy itself pledged as collateral, you can access upwards of 90% of the CSV.

Unlike a policy loan, this cash advance is not subject to taxation. The interest owing can either be paid annually or capitalized into the loan and repaid from the life insurance proceeds when you pass away.

Option 2 – Collateral loan or line of credit – Corporately-owned

A corporately-owned collateral loan or line of credit has the same basic structure as a personally owned equivalent. The lender will use the life insurance policy as collateral and the corporation receives the proceeds of the loan tax-free.

 However, one significant additional advantage is the ability to credit an additional capital dividend account (CDA) credit. When you pass away, the corporation receives a credit to the CDA equivalent to the face amount of the policy minus the adjusted cost basis (ACB). When there is a collateral loan or line of credit against the policy it creates an additional credit equivalent to the amount of the loan, allowing additional assets to flow out of the corporation tax-free.

For example: the company owns a $5,000,000 key man universal or whole life permanent insurance policy on one of its executives. 

• The business advances a collateral loan for $750,000, which is received tax-free by the corporation. 
• The interest is capitalized (added to the loan balance), while the corporation uses the funds for other business purposes. 
• When the executive passes away, the loan balance is $900,000. 

Since the collateral assignment did not affect the underlying life insurance policy, it continued to grow tax-sheltered and was worth $5,500,000 on death.

Let’s assume the ACB had been reduced to zero on death. This leaves a $5,500,000 policy to be credited to the CDA. The loan itself would need to be paid off, leaving $4,600,000 to be paid out to shareholders tax-free. Given that only $4,600,000 of the $5,500,000 credit to the CDA was used, this allows an additional $900,000 worth of assets to be paid out tax-free to shareholders, providing additional tax savings to the corporation.

When do I need to pay taxes on Life Insurance?

Although your life insurance premiums aren’t taxable, your life insurance benefits are taxable when:

• You don’t have a beneficiary
  • If you don’t have a beneficiary, your estate will be designated as the beneficiary and your death benefits may be taxed.
• Your policy has a cash value
  • If you want to sell a permanent policy for its cash value in return, your risk of getting taxed goes up because income earned as interest is usually taxable, and earnings on the payout of life insurance are considered income if you sell your policy.
• Your policy is loan collateral
  • If you use your permanent life insurance policy as loan collateral (ie. securing funds to pay for retirement), the part of your death benefit used to pay that loan back may be taxable in Canada. If there’s money left after the loan amount, your beneficiary will receive the rest and won’t be taxed on the remainder.
• You sell your policy
  • Depending on where you live, you can sell your permanent life insurance policy for cash if you no longer need it or afford it, or require cash. The money you receive from selling your policy is subject to tax, depending on the following:
    • The type of policy you had
    • The money you paid into it
    • The payment you got from selling it
    • And if the policy had any cash value

Frequently Asked Questions (FAQs) about life insurance and taxes

Do you have questions about life insurance and tax?

If you would like to discuss your unique tax circumstances, please contact Protect Your Wealth today. We are based out of Hamilton and support clients across Ontario with tax and insurance strategies that they can trust.

At Protect Your Wealth, we’ve been providing expert advice for all types of life insurance, and retirement and investing planning, since 2007. As your Life Insurance broker and financial planner, we work with you to create a personalized plan for your family or business that covers and meets your needs.

Contact Protect Your Wealth or call us at 1-877-654-6119 to talk to an advisor today. We’re proudly based out of Hamilton, and service clients anywhere in Ontario, Alberta, and British Columbia, including areas such as Milton, Victoria, and Edmonton.