Canadian Life Insurance Tax Laws

parliament of canada image by Scott Wormington from Fotolia.com The Canadian parliament makes all the laws, including the life insurance tax laws Canadian tax law affords life insurance products special exemptions that make them ideal vehicles for financial planning and money management. The preferred tax treatment of life insurance policies in Canada lends itself to advantageous planning techniques. Knowing as much as possible about those tax laws can help you make financial choices.

Tax-Free Death Benefits

In Canada, any death benefit proceeds paid out of a life insurance policy are not subject to income tax. This includes any amount above the insurance coverage purchased when issued. This amount could have been generated by investment returns or the purchase of additional insurance from dividends or investment returns. Split beneficiaries also receive their share of the death proceeds tax-free, including a situation in which one beneficiary is named for the insurance coverage and the other for the investment amount of the policy.

Participating whole life policies in Canada allow the policy owner to receive dividends when the mortality, investment and expense results exceed expectations. Dividends paid in cash are taxable. However, if those dividends are paid into the policy and used to purchase additional insurance coverage, they are not subject to tax.

Universal life policies in Canada allow for the payment of extra premiums that can be allocated to a variety of investment options inside the policy. The investments inside the universal life policy earn interest that is tax-exempt up to a certain limit as determined by the Canadian Income Tax Act. When that limit is close to being exceeded, the insurance company may increase the coverage by up to 8 percent annually. If the limit is exceeded nonetheless, excess investments must be withdrawn and are subject to taxation as interest income.

In most circumstances, including life insurance purchased by a business, premiums are not a deductible expense in Canada. However, two exceptions exist. First, if you purchase a life insurance policy and name a registered charity as the beneficiary, you can obtain a charitable donation receipt for the amount of the policy, which you can claim on your taxes as a deduction. Second, if you are applying for a loan and the lending institution requests that you buy life insurance as collateral, a portion of the premiums on that policy qualify as a deductible expense.

Cash withdrawals from a life insurance policy may be exempt from taxation provided the policy’s adjusted cost base (ACB) is higher than the policy’s cash value at the time of the withdrawal/surrender. The ACB is equal to the sum of premiums paid minus the sum of the insurance costs. If the ACB is lower than the cash value, any withdrawal (including a small partial withdrawal) is taxed as interest income in the same proportion as the ACB to the cash value.