Taxes 101 – Are Life Insurance Proceeds Taxable in Canada?

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Life Insurance Proceeds Taxable in Canada

Having life insurance can provide you and your loved ones with peace of mind if something happens to you. The death benefit of the policy (the amount paid to your beneficiaries) can be used to meet their immediate financial needs until they can figure out what to do.

However, what concerns most people is whether there will be any taxes on the proceeds; no one wants their last provision to their family to be taxed. So if you are wondering this, read on to know the answer and more.

So, Will The Government Take a Cut Out of My Life Insurance Proceeds?

Except for a few conditions, most of your life insurance proceeds will not be taxed. The death benefit your beneficiaries will receive from the life insurance policy will be tax-free. The lump-sum amount given to the beneficiaries can be used to finance several things.

This includes replacing the income so your loved ones can maintain a standard of living when you’re not around. It also includes debt payments, including your mortgage, so your loved ones can stay in the same home. It can also be used for paying funeral expenses and preserving your other assets, so they don’t have to be liquidated or sold.

Furthermore, it can also be used for charitable purposes if you selected a charity organization as the beneficiary. The gist is, in most conditions, your life insurance proceeds will not be taxed. Any beneficiary, be it your children, spouse, or someone else, will not have to report the proceeds from life insurance as their taxable income.

Keep in mind; it also does not matter if the policy is a term, or whole life insurance, or what its size is; it is not taxable in most conditions. However, there are some exclusions to this; in certain situations, the life insurance proceeds can get taxed.

When is My Insurance Proceeds Taxable?

There are certain conditions in which your life insurance proceeds may get taxed before landing in the bank accounts of your loved ones. Let’s discuss the major ones below:

If The Estate is Beneficiary:

If your estate is your life insurance policy’s beneficiary, then tax will be deducted on the death benefit. This can happen in two ways:

  •         If you made the estate a beneficiary of your life insurance proceeds
  •         If the beneficiary passes away before the life insurance policy proceeds are paid, and there’s also no contingent beneficiary

In both of these conditions, your estate will become the beneficiary of the proceeds. And as you may already know, there are some taxes to be paid when distributing the estate. Since the proceeds will become part of the total estate’s wealth, probate fees, estate settlement costs such as accounting, legal, and executor fees, and administration taxes will have to be paid before distribution.

So some part of these fees and taxes will be deducted in the life insurance proceeds that are not a part of the estate. Plus, any debts or taxes that the deceased owed will be cut from the estate’s money or assets, so a part of that amount will also be deducted from proceeds.

In some instances, taxes and fees on insurance proceeds can be avoided even if the estate is the beneficiary with the right financial planning for high net worth individuals. Visit WEALTHinsurance.com to learn more.

Interest Income:

The amount earned from interest is always taxable, no matter the business. This is true in the case of life insurance as well. If the insurance policy owner dies and their beneficiary waits for months to let the interest accumulate before getting the proceeds, then there will be taxes.

However, the tax will only be levied upon the interest earned and not on the entire death benefit. For instance, if the total death benefit is $30,000 and it earns an annual 10% of interest after being paid out, the beneficiary will pay $3000 in tax.

Taxes on Cash Value:

Unlike term life insurance, a permanent one usually has a cash value. It is the amount that’s added on top of the policy’s value because of the returns insurers made by investing the premiums you paid. If you want to withdraw from the policy and receive its cash value, there will be taxes.

Furthermore, with the cash value, there’s an option to use some or all of it to pay for loan collateral to the bank or a 3rd party lender. If you did, then some of the money you borrowed might be taxable. We’re saying ‘might’ because different states have different rules; be sure to ask your insurer about this before borrowing against the cash value.

Selling the Policy:

At the time of writing this, four provinces (Nova Scotia, New Brunswick, Quebec and Saskatchewan) allow life insurance policyholders to sell their policy to someone else.

When you sell the policy to someone, the buyer will get the death benefit and premiums. So the money you get from them by selling your policy may be taxable.

How to Report Tax on Life Insurance Earnings in Canada?

Lastly, if you are a beneficiary and find yourself in the first two situations mentioned above, or if you’re the owner who’s getting cash value from the policy, you need to file taxes on the amount.

The process is pretty simple; you need to get a T5 slip from the insurance company. The amount of money (interest earnings or cash value borrowed) will be reported in the slip, and then you can submit it. That’s pretty much it.

Parting Words:

Having life insurance should not be a highly complex part of your long-term financial plan. It is mostly non-taxable except a few situations mentioned above.

If you don’t borrow against the cash value and name your family members as beneficiaries with some contingents, you or your loved ones don’t really have to pay any tax.