Life insurance is a fairly popular service among Canadians. It allows you to provide your relatives with a fairly large payout after the death of the policyholder. The money can be spent for any purpose, so the insured person thus helps relatives cope with financial problems. However, many Canadians are wondering: is life insurance taxable in Canada, and will heirs have to pay extra costs? Let’s take a look at these nuances in our article.
Are life insurance proceeds taxable in Canada
So, is life insurance taxable in Canada? The principal amount received under a life insurance policy is not subject to income tax. The compensation is paid to the beneficiary in a lump sum and in full. The benefit will not need to be reported on your tax return, and it doesn’t matter what kind of insurance was taken out: term or life. The amount received can be used for the following purposes:
- repayment of loan obligations, including mortgages;
- payment of funeral and burial expenses of the policyholder;
- paying for children’s education and medical treatment;
- every day expenses.
Life is complicated and contingencies vary. For example, it is not uncommon for a beneficiary who is entitled to an insurance benefit to pass away before the policyholder does. In that case, the insured must choose another heir. If this does not happen, the compensation will be included in the inheritance estate.
How to make life insurance more effective for beneficiaries
To avoid paying income tax on the insurance benefit, the first thing to do is to designate specific individuals as beneficiaries when taking out the policy. This approach will not only help avoid additional problems, as in the case of a will but also obligate loved ones to pay off the debts left behind. Listing the names of the beneficiaries on the policy will also help speed up the process of transferring funds to the holder’s relatives since this information is confidential.
When insurance compensation is tax deductible
If you decide to take out a policy that is entitled to accrue interest, keep in mind that you will not only receive extra money. Along with them, your beneficiary will have to pay income tax on the accrued dividends after the policyholder dies. This amount is treated as income, so it is taxable.
If you decide, for any reason, to terminate the policy before the end of the term, you will also have to pay income tax on the amount by which the value of the insurance increased while it was in force. If the terms of the insurer do not provide for the payment of interest, then you won’t have to pay anything to the IRS.
The insurance compensation will also be subject to income tax if the policy serves as collateral for a loan. Tax will be calculated on the amount that will be used to pay off the debt. If there is money left in the policy holder’s account after the debt is paid, it will be paid to the beneficiary without any withholding after the holder’s death.
Insurance tax will also have to be paid if you decide to sell a permanent life insurance policy. This is usually what people do when they need cash in a hurry or can’t make premiums. You will need to report the amount you get from selling the policy on your tax return. Accordingly, you will have to pay tax on its value.
Is life insurance taxable in Canada: tax calculation rules
In most cases, you won’t have to report the life insurance benefit to the IRS. But, if you received interest income due to the death of the policyholder, that amount is subject to income tax. If this is your case, the insurance company will automatically issue a T5 receipt.
What is a T5
This is the common name for a tax return form on which you must enter detailed information about your investment income and benefits. Although insurance benefits do not need to be reported on the return, if you decide to cash out the policy, the form will be given to you to fill out. This document will serve as a statement of the life insurance income received.
If the taxpayer receives additional interest from investments, this is sure to be indicated on the T5 receipt. Each line of the document must be numbered, no errors are allowed.
What is line 12100 on a tax return
Prior to early 2020, this line was known as line 121. This is the name of the line on the tax return where a Canadian citizen lists the income received on a life insurance policy. This same information must be exactly the same as the T5 receipt issued by the insurance company. If the insurance involves the payment of dividends on the policy, this must be shown on line 12100. Such income is subject to income tax.
When to pay tax on insurance benefits
Tax can be paid in part or in full if it is a withdrawal from permanent life insurance if it is stated in the policy. You will also have to pay tax if you took out a loan and provided an insurance policy as collateral. Keep in mind that the loan amount should only be up to what is called the adjusted basis value.
If the loan amount exceeds that value, the taxpayer will have to pay tax on the difference. Such an obligation is imposed on you if you pledge or surrender the policy. Either way, the insurance company is watching your actions, so they will offer to fill out a T5 receipt.
Tax returns are filed after the reporting period. Usually, it is a year. That is, you must file your tax after one year. In some cases, this period may be extended – this will depend on the specific situation.
Will my heirs pay life insurance taxes?
After the death of the insured, in most cases, taxes will not have to be paid. However, in some situations, it will still be necessary. For example, if the terms of the policy involve the payment of dividends. Such income must be shown on the T5 receipt and tax return. That is, it will be calculated as income for the beneficiary.
Do I have to pay income tax if I receive interest on a life insurance policy?
Yes, in this case, you must file information about the income you receive and it is taxable. In such cases, the value of the policy is lower than the total amount insured, so the holder will have to pay income tax. This is because the insurance company needs to cover its own costs of maintaining the policy, and it has the right to set its own rules for reimbursing the insurance so as not to lose profits. Usually, these costs are initially built into the cost of the policy.
What can the insurance benefit be spent on?
The purpose of spending the money received after the policyholder dies is not important in most cases. But he or she can spell out in the document where the money is to be spent. For example, to pay for funeral expenses or to pay off loan obligations that were arranged during his lifetime. In any case, the testator always wishes his or her beneficiaries nothing but good and wants them to suffer no financial loss in the event of his or her death.