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Does life insurance get taxed?

In most cases, the payout from your life insurance won't be taxed — but there are some exceptions.

One of the main selling points of life insurance is that the proceeds are typically not taxable. There are a few situations where beneficiaries will have to pay tax — and they usually apply to permanent policies or policyholders with large estates.

This article is meant to be a generalized guide. With so much riding on your life insurance, speak with a licensed accountant to make sure you fulfill all of the tax obligations for your specific policy and circumstances.

When are life insurance proceeds tax-free?

Generally, your beneficiaries can dodge taxes in these situations.

Death benefit paid out to beneficiaries

Most people buy life insurance so they can leave money to their beneficiaries when they die. Fortunately, the death benefit isn’t considered taxable income, so the full payout will go to your beneficiaries who won’t have to declare it as taxable income.

Cash value gains

If you choose a permanent whole or universal life insurance policy, it builds cash value over time. The cash value gains are not subject to any taxation unless the policy is surrendered, or the cash value is accessed or removed from the policy.

Surrender payouts

If you decide to cancel your life insurance policy before it matures, you’re eligible to gain access to your accrued cash value minus any surrender fees. This is called a “life insurance surrender.” If you surrendered a permanent policy with a cash value component, you’ll have to pay taxes on the amount of any interest accrued on your investments.

How to use the cash value of your policy

Early payout for chronic or terminal illness

Many permanent life insurance policies offer riders or add-ons that cover unexpected chronic or terminal illness. These riders generally allow for an early payout of your death benefit to help cover your medical bills, long-term care and everyday expenses. Because such riders are an acceleration of death benefits, they are protected from taxation.

If you receive the money as monthly installment payments instead of one lump some, it’s a good idea to get the payments certified as accelerated death benefit payments through a tax professional. That will ensure that if the CRA looks into your finances you can easily justify the payments as being tax exempt.

Return of premium policy refunds

A return of premium (ROP) policy reimburses you for any premiums you paid if you outlive the policy. If you payed the premiums from your own income, generally, the CRA will see the ROP as a refund — not like a payment or profit — so the money you receive isn’t subject to tax.

Using your cash value as collateral for a loan

In this situation, you essentially apply for a loan at some financial institution and assign the cash value of your life insurance policy as collateral. Loan advances can be received without paying tax. In some situations, the interest on the loan may even be deductible, like when loan proceeds are used towards generating business or property income.

Are life insurance premiums tax-deductible?

Unfortunately premiums aren’t tax-deductible for individuals. A business, on the other hand, may be able to deduct the premiums they pay into a group plan on behalf of employees, as long as they won’t receive a benefit if the employee dies.

When is life insurance taxable?

Though life insurance has many tax benefits, there are a few situations when the proceeds of your policy may be taxed.

Interest earned on payout benefits

After you die, your life insurance beneficiaries often can choose to receive your policy’s death benefit as a lump sum or in installments over time. If they choose installments, the policy’s insurer holds the death benefit, which may accrue interest, depending on the account it’s held in.

In this case, the benefit’s principal avoids taxation, but any interest earned on it does not. So if your $250,000 life insurance benefit gains $25,000 in interest between time of your death and payout, your beneficiaries would likely owe taxes on the accrued $25,000.

To avoid this, beneficiaries should choose to receive the lump sum.

Annual life insurance dividends

Some insurers are mutual insurance companies, which means they’re owned in part by their policyholders. Policyholders with these companies are eligible to receive annual dividends on the company’s profits. If the dividends are paid out in cash, all or a portion of the amount may be taxable, and any interest earned on dividends is also taxable.

Profit from surrendering a cash value policy

If you cancel a cash value life insurance policy, you’ll have to pay taxes on the interest accrued on the cash surrender value. So the total amount you’ll receive back from your cash value is the portion you payed into it minus surrender fees and the taxable portion of the interest earned.

Loans against your policy

After a stated period of time, many permanent life insurance providers allow you to borrow from any cash value benefit you’ve accrued. Like most loans, you’re required to repay that loan with interest.

As long as the amount of the loan doesn’t exceed the policy’s adjusted cost basis (ACB), the amount is not taxed. If the loan amount is greater than the ACB, the entire amount of the loan is taxable. A nice perk in some situations, however, is that interest on the loan may be tax-deductible if the loan proceeds are used towards generating business or property income.

Cash value withdrawals

You may have the option to take money from the cash value of your policy as a withdrawal – meaning you don’t have to pay it back as you would a loan. Doing this might make sense because in many cases if you don’t use your cash value while you’re alive, you’ll lose it.

When your withdrawal amount exceeds the ACB, your withdrawal becomes taxable. When the ACB reaches zero, the entire amount of your withdrawal is taxed.

Profit from life insurance settlements

You may be able to sell your policy to a third-party for a one-time upfront payment. The payment to you is usually less than the death benefit but greater than the cash value. Keep in mind that most provinces in Canada don’t currently allow life insurance policies to be sold – with the exception of Quebec, New Brunswick, Nova Scotia, and Saskatchewan. Some companies may also not allow their policies to be sold even if it is permitted by the province, so check with your insurance company first to learn its stance on selling life policies.

The amount of your settlement is decided by you and the buyer, but any profit you make on your settlement may be taxable.

Failure to pass an exempt test

An exempt test is used to determine the purpose of a life insurance policy – whether it is used primarily to provide protection in the event of death, or as an investment vehicle. The test essentially compares the growth of the cash value compared to the size of the death benefit in your policy to a benchmark exempt test policy (ETP). If your cash value accrues relatively more annual interest than ETPs, then your policy will be classified as an investment vehicle and you’ll likely have to pay annual taxes on the interest earned.

Compare highly rated life insurance companies

Name Product Types of Insurance Coverage Range Issue Ages Medical Exam Required Province Availability
PolicyMe Life Insurance
Term Life
$100,000 - $10,000,000
18 - 75
No
AB, BC, MB, NS, ON, PEI, SK
Get fast and affordable term life insurance. Personalize your policy details and get an estimate price within seconds. No phone call, meeting or paperwork required. No medical exam required.
Walnut Life Insurance
Term Life
$50,000 - $1,000,000
18 - 70
No
AB, NS, ON, PEI
Access budget-friendly insurance plans and get instant coverage in minutes. No medical exam required. Plus, add Walnut member benefits and enjoy access to ClassPass, Headspace, Dashlane and more.
TermLite Term Life Insurance
Term Life
$10,000 - $1,000,000
18 - 80
No
All of Canada
Get fast and easy-to-understand term life insurance with no medical exam and no paperwork required.
RBC Life Insurance
Term Life
$50,000 - $1,000,000
18 - 70
No
AB, NS, ON, PEI
Select from two unique RBC term life insurance plans to get flexible and affordable coverage that suits your lifestyle and budget. Get a free quote through Walnut.
Sun Life Go Term Life Insurance
Term Life
$100,000 - $1,000,000
18 - 69
No
All of Canada
Sun Life Go Term Life Insurance is a standard term life insurance option that guarantees your premiums in the first 10 or 20 years of your policy.
PolicyAdvisor
Whole Life, Term Life, Universal, No Medical
$25,000 - $5,000,000
18 - 75
No
AB, MB, ON
PolicyAdvisor is a digital life insurance brokerage that has partnerships with 20 insurers in Canada.
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Compare up to 4 providers

Bottom line

Life insurance is a complicated coming together of two of life’s certainties: death and taxes. In most cases, the payout from your policy won’t be taxed. But there are a few situations where you or your beneficiaries will have to cough up taxes — like when you surrender the cash value of your policy.

With frequent changes to tax laws, speak to a licensed accountant or adviser if you have questions about the tax implications of your policy.

In the meantime, protect your loved ones by comparing your life insurance options.

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