Using Life Insurance for Tax Planning

When thinking about tax planning, you may be  surprised by the financial benefits a life insurance policy can offer.

Tax planning reduces your tax liability both during your lifetime and after your death. Fortunately, permanent life insurance can assist in both areas. Permanent life insurance not only provides your beneficiaries with a death benefit that is tax-free, but it also allows you to accumulate wealth that is tax-free and can be withdrawn at any time during your lifetime.

Continue reading to learn more about tax planning with life insurance.

Strategies to save money from taxes

Here are some strategies for using life insurance to reduce your tax liability. 

Irrevocable Life Insurance Trusts

For high-net-worth individuals, an irrevocable life insurance trust (ILIT) may be beneficial.

An ILIT allows you to do more than just keep track of life insurance policies; it also lets you to direct how the proceeds are used. However, once an ILIT is established, its parameters cannot be changed or terminated.

ILITs, like other trusts, involve the following three parties:

• Grantor: Someone who establishes and finances a trust.
• Trustee: The trustee, who is appointed by the grantor, is responsible for paying premiums on time and keeping the policy active. When the grantor dies, the trustee distributes the proceeds to the beneficiaries of the life insurance policy.
• Beneficiaries: Grantors name one or more individuals as policy beneficiaries.

Aside from tax advantages, an ILIT gives you more control over how your policy proceeds are spent. You can, for example, specify when and how your beneficiaries will be able to access the payout. However, if you name beneficiaries on your life insurance policy, they have complete discretion over how the money is spent.

Gift money now 

Assuming you are financially secure, you may prefer to give money to your heirs while you are still alive rather than leaving an inheritance after you die.

An early inheritance can be emotionally satisfying because you can see how it improves or simplifies the lives of your children. It may also have financial advantages. Giving money to the next generation while you are still alive reduces the size of your estate, lowering probate costs and estate taxes.

Your heirs can even use a portion of their inheritance to buy life insurance on you. They will receive another inheritance after you die (the life insurance payout).

Your Beneficiaries

Most people purchase life insurance primarily to protect the future of their families. Your policy proceeds can help your loved ones stay financially afloat after you are no longer able to do so. It can assist your surviving spouse in paying for education, supplementing their retirement income, and ensuring the well-being of the family.

You can transfer the death benefit of your life insurance policy to your loved ones tax-free. Your beneficiaries will not be taxed on the benefit they receive, regardless of its size. Other financial vehicles, such as tax-deferred annuities, individual retirement accounts, and qualified retirement plans, are not included.

Policy Loans and Taxation

Life insurance can help your family financially in the event of your death, but it can also be used for other purposes.

In addition to paying a death benefit, most permanent life insurance policies accumulate wealth — known as cash value — tax-deferred. As a policy owner, you can access the cash value of your policy at any time while you are alive. You can obtain it in a variety of ways, including through a policy loan.

A policy loan allows you to borrow money by using the policy's cash value as loan collateral. You can borrow up to 90% or 100% of the total cash value. All cash-value permanent life insurance policies are eligible for policy loans, but your policy must have enough cash value to borrow against.

A policy loan is different from other types of loans in that you are not required to repay it. You have the option of not repaying the money because you are essentially borrowing it. In that case, the insurer will deduct the loaned amount plus interest from the death benefit. In other words, if you do not repay the loan, your beneficiaries will.

You can borrow up to the adjusted cost basis (ACB) of your policy without receiving a tax slip. You must pay tax on the portion of the borrowed amount that exceeds the ABC of the policy.

A policy's ACB is the sum of premiums paid that are less than the net cost of pure insurance. Assume your annual premium for whole life insurance is $5,000. The net cost of pure insurance is $1,200, with the cash-value component accounting for $3,200 and various fees accounting for the remaining $600. In this case, your policy's ACB is $3,800.

Making withdrawals from your policy is another way to gain access to its cash value. The death benefit is generally reduced dollar for dollar. For example, if you withdraw $20,000 from a policy with a cash value of $60,000 and a death benefit of $500,000 when you die, your beneficiaries will receive $480,000.

Partially withdrawing more than the ABC of the policy will result in a tax slip, just like policy loans. However, you will not be required to pay tax on the entire amount. Rather, only the amount that exceeds your policy's ABC is taxable income.

Is the Cash Value of a Permanent Life Insurance Policy considered to be Passive Income?

The cash value of a permanent life insurance policy is not taxable as long as it remains within the policy. The tax advantages apply regardless of whether the policy is owned by a corporation or an individual. This means that while the cash value is covered by a policy, it is not considered passive income.

You will, however, realize a taxable gain if you take out a policy loan that exceeds the ACB of your policy. The same applies to partial cash withdrawals that exceed the policy ACB. You will almost certainly receive a tax bill if you cash in the policy, that is, surrender it for its cash value.

Are life insurance premiums tax-deductible in Canada?

One of the most common questions from policyholders is whether or not life insurance premiums are tax deductible.

The answer is that it depends. In most cases, insurance premiums do not reduce taxable income for individuals or corporations. They may, however, be tax-deductible in some cases.

Personally-paid life insurance policies

Premiums paid for a life insurance policy used as collateral for a loan may be tax deductible.

If a charity owns a life insurance policy, the premiums are tax deductible. Keep in mind that this is not the same as a personal policy with a charity as the beneficiary. In the latter case, the estate of the deceased will be eligible for a tax credit. 

Corporately-paid life insurance policies

If the corporation receives the insurance payout, premiums paid for a corporately owned plan are not tax deductible. A corporately owned policy, on the other hand, may be eligible for a tax credit if it is used as collateral for a business loan. A corporation's group life insurance premiums may also be tax deductible.

Is life insurance taxable in Canada? 

Life insurance proceeds are generally not taxable, but there are some exceptions. The death benefit is taxed depending on who receives it and how it is accessed.

When the beneficiary is a person or an entity

The proceeds from life insurance are not taxed. As a result, naming a person or entity (such as a charitable organization) as the beneficiary will result in a tax-free payout. This is true regardless of the amount of life insurance purchased. Whether the death benefit is $10,000 or $1 million, it is not taxable.

However, while the life insurance payout is tax-free, the death benefit earnings are. Some insurers permit policyholders to receive payment in installments. If your beneficiary chooses this option, he or she will be required to pay taxes on any death benefit interest earned.

When the beneficiary is the estate

If no beneficiary is named, the life insurance proceeds are paid to the deceased's estate. To begin, as the owner of the policy, you can name the estate as the beneficiary.

When a death benefit is transferred to the estate of the deceased, it is taxed along with the rest of the estate. As a result, experts recommend that the estate not be named as the beneficiary.

Does life insurance go through probate? 

Life insurance proceeds can avoid probate, which is the legal process of authenticating and validating a deceased person's will. Almost every will in Canada must be probated before the estate can be distributed among the heirs in accordance with the deceased's wishes. However, probate is an expensive process. How much is it? That is largely determined by the size of the estate. Because life insurance proceeds are not typically considered part of your estate, the payout reduces your tax liability at death while also lowering probate costs.

Most of the time, the insurance proceeds are paid directly to the beneficiary, bypassing probate. However, in a few cases, life insurance must go through probate. These include: 

• When the policy has no beneficiary
• None of the beneficiaries are alive or traceable
• The estate is designated as the beneficiary
• A minor is named as the beneficiary

Is there sales tax on life insurance premiums in Canada?

Life insurance premiums are neither subject to the Provincial Sales Tax (PST) or Harmonized Sales Tax (HST). Therefore, you do not have to pay sales tax on your premium payments. 

Life insurance as a tax shelter in Canada

Permanent life insurance accumulates cash value that grows tax-free, which means you only pay taxes on investment gains when you access the cash value. This arrangement may assist you in accumulating more cash value while lowering the total amount of tax you will pay on investment gains.

Permanent policies, due to their built-in cash value component, are a viable alternative to traditional investment vehicles such as RRSP, RESP, and TFSA. The two types of permanent plans that build cash value are whole life insurance and universal life insurance. Whole life policies provide a fixed rate of return, whereas universal life plans have cash value growth that varies with the market rate.

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What are the tax consequences of cashing out life insurance?

Even though permanent life insurance policies provide tax-sheltered growth, you may be required to pay taxes when you access the cash value, either partially or entirely.

Any amount that exceeds the policy's ACB when you make a partial withdrawal from the cash value is taxable. Similarly, if you surrender the policy for its net cash value (cash value minus surrender charges), any amount over the ACB will be taxable. 

When do I need to pay taxes on Life Insurance?

For the most part, life insurance benefits are not taxable. However, in certain situations, they can be taxable. These include: 

When the insurance proceeds go to the deceased’s estate

If the death benefit is paid to your estate, it may be subject to tax. Your estate could end up receiving the insurance payout in the following scenarios: 

• You have named your estate as the beneficiary (Most life insurance experts advise against naming the estate a beneficiary, as it can be taxable)
• Your primary beneficiary predeceased you and you didn’t update the beneficiary designation (Policy holders should regularly revisit their beneficiary designations, particularly after a major life event)
• Your primary beneficiary is untraceable and there is no secondary beneficiary (It is always a good idea to name a secondary beneficiary. He or she receives the insurance payout if the primary beneficiary is no longer alive or traceable) 

When you withdraw funds from your cash-value life insurance

The cash value of your permanent life insurance policy is available to you for use during your lifetime. The insurer only pays the death benefit to your beneficiaries, not the cash value. A policy loan, a cash value withdrawal, and policy surrender are three of the most common ways to access the cash value.

Your policy’s cash value is made up of two parts: 

• The money that you paid in the form of policy premiums. You do not pay tax on this part of your cash value 
• The money gained from interest. This component is taxable. 
• When you make a withdrawal, only that part which exceeds the adjusted cost basis (ACB) — the sum total of the premiums paid less the net cost of pure insurance — is regarded as taxable income.

For example, your policy has a cash value of $50,000, out of which $40,000 is the ACB. When you withdraw the cash value, you pay tax on the amount that exceeds your policy’s ACB. So for a $42,000 withdrawal, you will receive a tax bill for $2,000. But if you withdraw $21,000, you will not have to pay tax. 

When you surrender your policy

Life insurance requirements evolve with age. There may come a time when your life insurance policy's financial needs are no longer met. If this occurs, you can safely cancel your policy.

Surrendering a policy means cancelling coverage. Since permanent life insurance plans accumulate cash value, you may be able to receive a certain amount (known as the net cash value or surrender value) when you cancel the policy. You may be required to pay tax depending on the size of the surrender value.

Continuing with the previous example, let's say the cash surrender value of your policy is $48,000. This means you must report $8,000 as income on your tax form for that year (because the policy's ACB is $40,000).

When you take a policy loan and the coverage terminates 

A policy loan allows you to borrow money from the insurer while using the cash value of the policy as collateral. For as long as the coverage is in effect, the borrowed amount is not taxable. If you cancel coverage before repaying the loan, you must pay tax on the portion of the loan that exceeds the ACB of the policy.

When you sell the policy

Life settlement is the process of selling your life insurance policy to another person or entity for a one-time, lump-sum payment. In general, the selling price is greater than the net cash value of the policy but less than the death benefit.

Only four Canadian provinces permit life settlements: Quebec, Nova Scotia, New Brunswick, and Saskatchewan. Remember that life settlements are taxable to the extent that you make a profit. If you receive more money than you paid in premiums, the CRA will take a cut of the profits.

Assume you raised $75,000 by selling a permanent life insurance policy for which you had paid $37,000 in premiums. Because your profit is $38,000, it is taxable.

When the death benefit is issued installments

Your beneficiaries can choose how they want to receive the insurance payout. Most people prefer a lump sum, but monthly installments over a set period of time are also an option. If you choose the second option, you will almost certainly have to pay tax because the interest earned on the insurance proceeds is taxable.

The bottom line

Permanent life insurance can be a useful tax planning tool. Not only is the death benefit tax-free, many policies also have a saving component that accumulates wealth on a tax-advantaged basis. If you are a high-net-worth individual who has maxed out traditional investing vehicles, like your RRSP, consider taking out a permanent life policy.

Want to know more about how you may utilize permanent life insurance for tax planning? Need help locating the best policy for your family? You can reach out to us here at Dundas Life. We will support you in every manner possible.

Frequently Asked Questions

Are life insurance premiums tax-deductible? 

Life insurance premiums are not generally tax deductible. However, if you pay for life insurance premiums for your employees as a business owner, you may be able to deduct them as a business expense.

Will my beneficiaries receive a tax bill on the death benefit they receive? 

Although life insurance proceeds are tax-free, any interest earned on them is. As a result, if your beneficiaries elect to receive a lump-sum benefit, they will not be required to pay any tax. However, if they choose to receive the payout in installments, they will almost certainly be taxed on the interest earned on the death benefit. 

Would I have to pay tax on the cash value of my policy? 

The cash value grows tax-deferred, which means you only pay taxes on it when you withdraw it. You must pay tax on the amount that exceeds the policy's adjusted cost basis if you surrender the policy, make a partial withdrawal, or take a policy loan.

Is life insurance an inheritance? 

No, because it is not part of your estate, life insurance is not an inheritance. Life insurance does not have to go through probate for this reason alone.