Tax rules for life insurance

One of the particularly valuable aspects of life insurance is that the amount paid to the beneficiary at the death of the insured is received tax-free. Life insurance is one of the few remaining sources of funds that offer this important feature.

Many Canadians, however, may not realize that there are circumstances where the proceeds of an insurance policy will be subject to taxation. Generally speaking, if the policy is surrendered (cashed in, in other words) at any point other than death, it will be given virtually the same treatment as any other piece of non-capital property that is sold. This is to say that, if there is a gain, that gain will be taxable.

The Canada Customs and Revenue Agency (CCRA) talks about a “disposition”, which includes policy surrender, maturity, annuitization, absolute assignment (but not assignment as collateral for a loan, however), or lapse (which means a policy that has lapsed from non-payment of premiums and that has not been reinstated within 60 days after the end of the calendar year). Disposition also includes the voiding of an insurance contract by the insurer because of misrepresentation by the insured. The basic calculation of what wou be payable is as follows:

Cash surrender value – all premiums paid + all dividends declared = taxable policy gain.

Let’s plug some numbers into this formula and see what we get. Let’s say you are a policyholder who surrenders a policy that had been in force for 10 years and the cash surrender value is $10,000, annual premiums paid were $750, and dividends declared totaled $1,500. The taxable policy gain would be:

$10,000 – (10 x $750) + $1,500 = $4,000

So the policyholder would report the $4,000 gain on the tax return in the year that the policy was “disposed of.

Feel overwhelmed by the idea of having to figure this out for yourself? Don’t be. Your insurer keeps you informed annually as to the cash surrender value (CSV) of your policy, and will be pleased to help you with the rest of the calculation – if it ever becomes necessary. So if you’re thinking of cashing in, make sure you understand all the consequences before you make a decision – including the amount of tax you’ll be facing.