Are Life Insurance Benefits Taxable in Canada?

Life insurance provides funds to beneficiaries upon the death of the insured. In Canada, while the primary death benefit is generally tax-free, other aspects of a life insurance policy, especially those with living benefits or investment components, can have tax implications. Understanding these nuances is important for policyholders and beneficiaries to plan their finances and avoid unexpected tax liabilities.

Understanding Death Benefit Taxation

For the vast majority of individual life insurance policies in Canada, the death benefit paid to a named beneficiary is generally received tax-free. This tax-exempt status applies whether the policy is a term life insurance policy, which covers a specific period, or a permanent life insurance policy, such as whole life or universal life, which provides coverage for an individual’s entire life. The Canada Revenue Agency (CRA) typically views these payouts as a capital receipt rather than taxable income, meaning beneficiaries do not need to report the amount on their income tax returns.

This tax-free treatment provides financial security to loved ones. The proceeds can be used for various purposes, including income replacement, debt repayment, or covering final expenses. This applies whether the beneficiary is an individual, such as a spouse or child, or an entity like a charity.

There are, however, rare exceptions where the death benefit might face tax implications, though these are not typical for individual policyholders. If no specific beneficiary is named on the policy and the death benefit is paid to the deceased’s estate, the funds become part of the estate. While the death benefit itself remains non-taxable, the estate may be subject to probate fees or used to cover the estate’s debts, which can indirectly reduce the amount ultimately received by heirs.

If a policy is owned by a corporation and the corporation is the beneficiary, the tax treatment is more complex. The excess of the death benefit over the policy’s adjusted cost basis (ACB) is credited to the corporation’s capital dividend account, potentially allowing for tax-free distribution to shareholders.

Another exception involves policies assigned for value, where the policy has been sold or transferred. In such cases, proceeds may be subject to different tax rules. For most individuals, naming a specific beneficiary ensures the death benefit bypasses the estate and is received directly. This provides beneficiaries with immediate access to funds without probate delays or costs.

Taxation of Living Policy Benefits

While death benefits are generally tax-free, benefits received from a life insurance policy during the policyholder’s lifetime, often from permanent policies with a cash value component, are subject to different tax rules. These “living benefits” include cash value withdrawals, policy surrenders, and policy loans, each with distinct tax implications. The concept of Adjusted Cost Basis (ACB) is central to understanding the taxation of these benefits.

The ACB of a life insurance policy represents the premiums paid into the policy, adjusted for certain costs. It is the portion of the policy’s value funded with after-tax dollars, which can generally be received tax-free. ACB calculation can be complex and typically decreases over time.

When making cash value withdrawals from a permanent life insurance policy, amounts received up to the policy’s ACB are generally tax-free. This is considered a return of the policyholder’s capital. However, any amount withdrawn that exceeds the ACB is considered a taxable gain and must be reported as income for tax purposes. This taxable portion is then subject to the policyholder’s marginal income tax rate.

Surrendering a policy means exchanging it for its cash surrender value. If the cash surrender value exceeds the policy’s ACB, the difference is a taxable gain included in the policyholder’s income. The insurer will issue a T5 slip for this gain, which is taxed as ordinary income.

Policy loans, where money is borrowed against the cash value, are generally not taxable income when taken, as they are treated as debt. Interest is charged, and any outstanding loan balance is usually deducted from the death benefit. However, if a policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the policy’s ACB may be deemed a disposition and become taxable income.

Tax Considerations for Policy Dividends

Participating life insurance policies offer policyholders the potential to receive policy dividends, which represent a share of the insurer’s surplus earnings. These dividends are distinct from corporate stock dividends and have different tax treatments depending on how they are used. Policyholders typically have several options for how they receive or apply these dividends, each with specific tax implications.

When policy dividends are received in cash, they are generally considered income if the amount exceeds the policy’s Adjusted Cost Basis (ACB). The insurer will typically issue a T5 slip for such amounts, which the policyholder must report. Receiving dividends in cash also reduces the policy’s ACB, impacting future gains if the policy is later surrendered or withdrawals are made.

If dividends are used to reduce future premium payments, they are generally not immediately taxable. However, this method also reduces the policy’s ACB, meaning a larger portion of any future cash value withdrawals or surrender proceeds could potentially become taxable.

Dividends can also be used to purchase paid-up additions (PUAs), which are small, single-premium policies that add to the policy’s death benefit and cash value. When dividends are used in this manner, they are typically not taxable at the time they are applied. Their growth contributes to the overall cash value, which could lead to taxable gains if later accessed.

When dividends are left to accumulate within the policy with interest, the interest earned is generally taxable annually. The insurer will provide a T5 slip for this interest income, which must be reported. This option allows dividends to compound, but the annual taxation of interest differs from the tax-deferred growth of the policy’s core cash value.