How Taxes Affect Life Insurance: What You Need to Know

Mark Virgil Lofranco • 5 October 2024

Understanding Life Insurance and Its Tax Implications


Life insurance is more than just a means to cover end-of-life expenses or manage tax liabilities for your survivors. It can also offer financial benefits during your lifetime, but it's essential to understand its tax implications.


What is Term Life Insurance?


Term life insurance provides coverage for a specific period, such as 5 to 30 years. If you die during the term, your beneficiaries receive the death benefit. This policy has no cash value, and premiums are not refundable. Group term life insurance, often provided by employers, operates similarly but may have additional tax considerations for employees.


Understanding Life Insurance Premiums


Premiums are the payments you make for your coverage. They vary based on factors like age, health, policy type, and coverage limits. Premiums for employer-paid life insurance are considered taxable benefits and must be reported on your T4 slip.


What is Permanent Life Insurance?


Permanent life insurance, including universal and whole life types, provides coverage for your entire lifetime and includes an investment component. You can build investments within the policy, tax-free. This type of insurance helps cover long-term needs, such as funeral costs.


Tax Implications of Life Insurance Distributions


  • Death Benefits: Death benefits are generally non-taxable. Beneficiaries do not pay income tax on these funds, allowing them to be used fully as intended.
  • Estate Planning: Naming your estate as the beneficiary of your life insurance can help cover final taxes, as the CRA does not charge inheritance taxes. The final tax return must account for capital gains, and any remaining estate funds pass to your heirs.


Cashing Out a Permanent Life Insurance Policy


You can withdraw funds from a permanent life insurance policy before death, but any gains are taxable. Here’s how it works:


  • Withdrawals: A partial surrender is considered a disposition. You must report any taxable gains based on the Adjusted Cost Base (ACB) and the cash surrender value (CSV).
  • Taxable Gain Calculation: For a partial withdrawal, calculate the taxable gain by subtracting the prorated ACB from the amount withdrawn. For instance, if you withdraw 25% of the CSV and the ACB is prorated, the taxable gain is the withdrawal amount minus the prorated ACB.


Example: If you have a $27,000 CSV and an ACB of $0, the entire $27,000 is taxable.


Conclusion


Understanding the tax implications of your life insurance policy helps you make informed decisions about coverage and withdrawals. Whether dealing with term or permanent policies, being aware of how these policies affect your taxes ensures you manage your finances effectively.


Key Takeaways


  • Death Benefits: Typically, life insurance death benefits are non-taxable and do not need to be reported on your tax return.
  • Permanent Life Insurance: Includes an investment component, allowing tax-free growth, but withdrawals may have tax implications.
  • Pre-Death Distributions: If you withdraw funds from a permanent life insurance policy before death, you may owe taxes on any policy gains.

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