Life insurance as a tax shelter in Canada
Cash value life insurance policies (including universal life and whole life) have significant tax advantages.
Permanent policies have a cash value that grows tax sheltered. As investment vehicles, they present an alternative to accounts such as:
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.
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.
Therefore, corporately-owned permanent life insurance policies provide a unique tax shelter with key advantages. More specifically, growth inside the policy does not reduce the federal small business deduction (SBD).
Due to recent federal tax changes, corporations earning in excess of $50,000 of investment income see their SBD completely eliminated, but the growth of assets inside corporately owned policies have no impact on it.
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.
When you partially or fully surrender a policy, the ACB has the greatest impact on your potential tax liability. Any amount over the policy’s ACB is taxable.
For example, the ACB of your whole life insurance policy is $25,000 and its cash value is $100,000. You could withdraw up to $25,000 tax-free but the remaining $75,000 is taxable. How much you owe will vary depending on your personal tax rate.
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
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, including areas such as Milton, Burlington, and Oakville.