Is life insurance taxable in Canada?
Is life insurance taxable in Canada?
Most of the money received from a life insurance policy is not subject to income tax. The death benefit paid from a life insurance policy is a tax-free, lump-sum amount for the beneficiary that can be used to finance a number of things. This includes paying off debts, including a mortgage, so your family can remain in the same home and community. It can also be used to replace income, so your family can maintain their standard of living without you. It can pay for funeral expenses and preserve other assets, so they won’t have to be sold or liquidated. Additionally, it can provide for your children and dependents, or you may elect to give to a charity of your or your beneficiaries’ choosing. Your spouse, child or anyone else you’ve named as a beneficiary would not have to report life insurance proceeds as taxable income on their Canadian tax return. It doesn’t matter whether the life insurance policy was term insurance or whole insurance, or how big the policy was.
Now, we said “most” of the money isn’t taxable for the beneficiaries. So, what is? How complicated is it?
If the estate is named as the beneficiary, or if the beneficiary predeceases the life insured and no other (contingent) beneficiary has been named, then the proceeds on death of the life insured are paid to the deceased’s estate. This is where things get tricky: “There may be probate fees, estate administration taxes and estate settlement costs like executor, legal and accounting fees that would need to be paid out in addition to any debts or taxes owed by the estate before any money or assets can be distributed to beneficiaries under the deceased’s will,” says Peter Wouters, director of tax, retirement and estate planning services at Empire Life Insurance Company in Kingston, Ont. He adds that if no will was created, each province outlines who gets the assets, how much each person gets, and in what order. When there is no will for someone who died, that’s called “dying intestate.”
How to make your life insurance more efficient for beneficiaries
Life insurance, funeral plans and investments are all important parts of a proper estate plan, which can provide emotional and financial relief for your loved ones. How do things like a life insurance policy, funeral planning and investments play a role for said beneficiaries? How can you make taxes less of an impact on them?
First, the most important thing to do: File the names of your beneficiaries with the insurance company. “This may avoid probate and associated costs, as well as most outstanding debts owed by the deceased life insured,” says Wouters. “There are exceptions, like dependents relief, where the deceased had an obligation to provide for dependents, particularly under a separation or divorce agreement.” Naming beneficiaries on a life insurance policy may also speed up the settlement process, getting funds into the hands of beneficiaries faster and with privacy, since these payouts, unlike a will, do not form part of the public record. The more you prepare, the better it is for your loved ones.
“Life insurance proceeds on death can also be used to pay for income taxes owed by the deceased and their estate on earned income; investment income, including capital gains; registered retirement savings plans [RRSPs] if a spouse has not been named as the sole beneficiary; and registered retirement income funds [RRIFs] if a spouse has not been named as either the sole beneficiary or successor owner,” says Wouters. “Life insurance can also provide lump sums of cash and income to replace the income lost by the death of the life insured. Using investments for these purposes may mean selling them when the markets are down and losing opportunities for market rallies and increased values. Selling investments may trigger unrealized capital gains that must be reported and paid to the government before any distributions to beneficiaries.”
Lending institutions such as banks, trust companies and credit unions may require insurance as additional collateral on loans, in case the borrower passes away before it’s fully paid back. “If there is an outstanding amount, the lender will subtract the loan amount from the total proceeds on the death of the life insured,” says Wouters. “The borrower’s estate or named beneficiaries get the balance. Life insurance as collateral may be for up to a certain percentage of its cash value and/or its sum insured [the amount paid on the death of the life insured].”