Is Life Insurance Tax Deductible in 2024?

Life insurance is an important financial investment, providing the ones you care about financial protection in return for life insurance premiums. But is it possible to offset the cost? And, can you deduct life insurance premiums from your taxes?

Life insurance, like many other investments, is generally not tax deductible. However, if you are a business owner and pay life insurance premiums for others, those life insurance premiums can be deductible.  

What is an income tax deduction?

An income tax deduction is an expense that lowers your taxable income, thereby reducing your income tax liability. You can subtract this amount from your gross income while completing a tax form to reduce your income tax. The lower the taxable income, the less you will pay in tax.

Why is life insurance not deductible?

A Life insurance premium is regarded as a personal expense. Consequently, tax deductions do not apply to it. In most situations, the payouts are also not taxable. In other words, insurance beneficiaries generally do not have to report the cash benefit on their income tax returns.

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Scenarios when life insurance is deductible

If you run a business and pay life insurance premiums on behalf of your employees, the expenses are tax deductible.

However, to qualify you must meet the following two requirements:

• You must offer life insurance as part of the employee benefits package
• Your company or you or any other business owner should not benefit from the life insurance policy

If you regularly pay the life insurance premiums and the rate does not change based on gender or age, you can write off the entirety from your income tax.

However, if you do not pay the insurance costs on a regular basis or the rate changes according to gender or age, you cannot deduct the entire cost as a business expense. Instead, get in touch with the Canada Revenue Agency (CRA) directly to find out what part of your expense you can write off.

Why is life insurance important?

When you pass away, the financial burden on your loved ones might be overwhelming. For your loved ones to continue living comfortably in your absence, a life insurance policy can provide a tax-free lump sum equal to your policy's death benefit. Once you pass away, your loved ones won't have to worry about spending down their savings.

There are insurance plans where the cash value accumulates interest. This is useful for other reasons as well, including retirement preparation.

Life insurance can be used to pay health care expenses, retirement planning, and so on. It provides protection and helps your family after you are gone. They wouldn't have to dip into their savings. Make sure to purchase coverage from a reputable top life insurance company.

Do you have to pay taxes on life insurance?

Under normal circumstances, neither you nor your beneficiaries pay taxes on life insurance benefits. However, there are some exceptions.

Surrender of life insurance policy

Permanent life policies accumulate cash value over time. This is an in-built investment account which grows on a tax-deferred basis. Your policy’s cash value is meant for your use while you are still alive. As a policyholder, you can access the cash value in multiple ways. You can take a loan against it or withdraw from your policy’s cash value. Additionally, you can also surrender the policy for its surrender cash value.

Surrendering a permanent life plan is the same as cancelling it. When you do that, the insurer pays you the cash value, minus any surrender charge. In the initial few years, the surrender charge is quite high, but over the course of time it gradually phases out.

Your policy’s cash value is combination of two things: the insurance premiums you have paid and the investment gains. The amount you pay into the life insurance policy (that is, the premium dollars) is referred to as the cost basis or the policy basis. If your surrender cash value is greater than this amount, the remaining amount is deductible. For example, say you paid $30,000 in premiums and your policy’s cash surrender value is $35,000. So, you will have to pay tax on $5,000 only (the amount you received minus the cost basis).

Withdrawal from the policy

You may need some money if someone has an unexpected health care expense. Another way to access the policy’s cash value is by making a withdrawal. Your withdrawal will be deductible if it exceeds the policy basis (the amount you have paid into the insurance policy so far). However, you will not have to pay tax on the entire amount but rather only on the investment gains.

Sale of life insurance

Selling a life insurance policy that you no longer need can help you raise some cash. Generally, people sell their life policies if they develop a terminal health illness or cannot afford the insurance costs.

The legal sale of an existing insurance policy to a third-party for a one-time cash payment is called a life settlement. The purchaser pays future premiums and becomes the policy’s life insurance beneficiary. Upon your death, they receive the death benefit amount.

In Canada, life settlements are legal in only two provinces — Quebec and Saskatchewan. If you reside anywhere else, you cannot sell your life policy. Also, some top insurance providers (like Sunlife insurance) do not allow policyholders to sell their life policies, regardless of which province they are in.

Selling a life policy removes insurance costs but can have tax implications. However, this depends on which type of policy you have.

Term life policies do not build cash value, but whole life and universal life policies do. In the case of term life insurance, the sale is generally for the amount you have paid into the insurance policy. However, in the case of a whole life or a universal policy, the purchaser usually pays more than the policy’s cash surrender value but less than the death benefit.

When you sell a life insurance policy, any gain from it will be subject to income tax.

Here is an example: Let’s say you have an insurance policy for which you have paid $20,000 in premiums. But now you are finding it difficult to afford the insurance premiums. So, you want to sell it to a third-party, who is willing to pay $28,000.

If you go ahead with the life settlement, you will pay income tax on the difference between the amount you receive from it and your cost basis in the policy (which, in this case, is $8,000).

Termination of coverage

If your insurance policy has a cash value component, you can borrow against it. The insurance policy loan is not subject to tax while the policy is active. However, if the coverage terminates before the loan has been paid back, you might have to pay tax.

You will not have to pay tax on the entire loan amount, though. Instead, only that part of the loan that exceeds the policy basis will be subject to tax.

Policy’s proceeds

If you named your estate as your beneficiary, the insurer would issue the death benefit to your estate. As a result, it will be liable to estate taxes and other fees associated with the distribution of an estate.

Once these costs are paid, the remaining amount will be distributed among your heirs according to your last will. In other words, your heirs will receive less money than you intended them to receive. For this reason, naming the estate as a beneficiary is not a great idea.

That said, your estate can get the payout even if it you did not designate it as your beneficiary. This can happen when:

• Your primary beneficiary predeceases you
• You did not name any beneficiary

Life insurance beneficiaries come in two types — primary and secondary (or contingent). Upon your death, the insurer pays the death benefit to your primary beneficiary. If the primary beneficiary dies before you do, the proceeds go to your contingent beneficiary.

If you did not name anyone as your beneficiary, or if your primary beneficiary predeceases you and there is no contingent beneficiary, the insurer will pay the benefit amount to your estate. Do not want that to happen? Make sure you keep your beneficiary designations up-to-date.

Installment benefits

Your beneficiaries can choose to receive the policy’s proceeds in different ways. While most people prefer a lump sum, your beneficiaries can opt to receive the payout in installments. However, in this case, any interest earned on the death benefit will be subject to tax.

Life insurance can be used to pay health care expenses, retirement planning, and so on. It provides protection and helps your family after you are gone. They wouldn't have to dip into their savings.

Conclusion

Life insurance provides financial protection to your family in the event of your death. In most cases, tax deductions do not apply to life insurance premiums. The only exception is if you own a business and provide insurance to your employees as part of their benefits package.

As far as the death benefit is concerned, your beneficiaries do not have to report it on their tax returns, unless they receive the policy’s proceeds in installments. In that case, any interest earned on the death benefit will be taxable. However, if your estate receives the proceeds, the payout will be subject to estate tax and other legal fees.

If you have any questions regarding the tax implications of your life insurance policy, a Dundas Life insurance advisor can give you personalized advice.