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Tax Treatment of Life Insurance in Canada

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The taxation of life insurance products in Canada is a complex and technical subject. The rules change frequently. This article will explain some of the “in’s and out’s” of the subject.

The first point to remember is that the life insurance contract creates three separate legal interests. These are:

  1. the insured – the individual whose death ultimately causes the policy to “mature” as a death claim;

  2. the owner – the individual who can exercise the policy’s five contractual rights:

    1. the right to change the beneficiary,
    2. the right to pledge the policy as collateral for a loan
    3. the right to assign the policy
    4. the right to surrender the policy for cash (except term insurance policies), and
    5. the right to borrow against the policy from the insurer; and

  3. the beneficiary – the party who will be receiving the proceeds of the death benefit upon the death of the insured.

It is possible for the same individual to be both the insured and owner of the insurance policy. This is often the case in family situations where one spouse is insured and owner, while the other spouse is the beneficiary. In other cases, the beneficiary and the owner may be the same individual. In still other cases, the three legal interest are held by three separate individuals.

Life Insurance Payments at Death

When policy proceeds are received by the beneficiary upon the death of the insured, no federal or provincial incomes taxes are payable on the amount received. This is one method of transferring assets from one generation to another, tax free. In some cases, the policy proceeds are not taken as lump sum but are left on deposit with the insurer and paid in installments. When this happens, the installment is considered to have been paid out partly in the form of the policy proceeds and partly in the form of interest. The latter portion is taxable upon receipt.

Life Insurance Payments during Life

A taxable gain will arise if the amount received from a policy in the form of dividends and cash values is greater than the amount paid in through premiums. Such income is taxable in the year it is received. Here is an illustration:

Premiums paid $ 16,700
Less: Dividends received 5,500
Cash basis of policy $ 11,200

If the owner surrenders the above policy and receives a cash payment in excess of $11,200, the difference is subject to income tax in the year that the surrender is made. However, no income tax loss arises if the policy is surrendered for less than the policy’s cash basis.

Using the policyholder loan provision should always be considered as an alternative to surrendering the policy. The amount of cash generated will be identical in both situations, but using the loan provision leaves the policy in force. The loan itself, or just the interest due upon it, can be repaid at a later date. On the other hand, if the policy is surrendered, all contractual rights end at that time.

Annuities

Annuity contracts are usually purchased to provide a lifetime income to one or more beneficiaries. Similar to the treatment of policy proceeds that are not taken as one lump sum, each annuity payment is divided into portions of principal and interest with only the latter portion being subject to tax. When you decide to (or must) begin to receive a retirement income, you can convert your Registered Retirement Savings Plan to either a Registered Retirement Income Fund or an annuity.

Corporate Owned Life Insurance

Some shareholders of privately owned corporations choose to have their life insurance policies held by the company rather than in their individual names. In these cases, the death benefits less the adjusted cost base of the policy are placed in the company’s “Capital Dividend Account”. The directors of the company may then elect a tax-free capital dividend to be distributed to the shareholders, thus transferring cash from the corporation to its individual owners tax free.

Article ©1998 The Quarterly Dividend
Reprinted with permission

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