As tax season rolls around, you may be wondering where life insurance fits into the picture. Do you need to report your life insurance policy on your tax return? How will taxes affect your life insurance policy in the future?
Understanding how your policy works when you die, can help your beneficiaries experience the full benefit of the money you leave behind. Ensure you take the necessary steps to protect your loved ones.
So, is life insurance really taxable?
For the most part life insurance in Canada is considered non-taxable which can be appealing since your beneficiaries will be able to collect the full death benefit. By non-taxable we mean that your beneficiaries won’t need to pay income tax on the amount they receive when you die.
This is the case regardless of the size of the policy, your partner, or anyone else you’ve named as a beneficiary. If you’re choosing between term and permanent life insurance policies, don’t worry both of these are considered non-taxable insurance plans.
Since life insurance is non-taxable, you do not need to report the interest gained on your death benefit on your annual tax return.
However, there are certain unique situations where life insurance is taxed.
When will you need to pay taxes on life insurance?
1. No beneficiary
If you do not appoint a beneficiary to your life insurance policy, when you die your estate will automatically be the designated beneficiary. If your estate is the beneficiary, then your death benefit may be subject to tax. The best way to avoid this tax is by ensuring that you designate a trusted beneficiary.
2. Loan collateral
Another reason you may need to pay taxes on your insurance policy is if you have used your life insurance policy as collateral for a loan. This means if you die your loan provider will pay off the loan using the death benefit from your insurance policy. Your family/ beneficiary will have to pay taxes on any outstanding loan balance that exceeds what you paid into the policy.
3. Selling your policy
Four provinces (Quebec, New Brunswick, Nova Scotia, and Saskatchewan) in Canada allow you to sell your life insurance policy to another person. When you sell your policy, the buyer will receive the premiums and the death benefit. The money you get from selling your policy may be taxed. The way it is taxed will depend on the type of policy, the money you paid into it, the amount you received from selling it, and whether there was any cash value.
How your family can benefit from tax-free life insurance
Most of the time your death benefit will be non-taxable which means your beneficiaries can gain the full value of your death benefit. Taxes can be frustrating since they take away some of the money your family is entitled to. The entire amount of a life insurance policy when paid out should be tax-free. Although, this may not be the case based on other investments (like real estate or RRSPs) where the beneficiaries would be expected to pay taxes or be taxed on the estate.
Overall, life insurance can help support your family’s living expenses. The money can help them maintain their quality of life and not have to worry about making ends meet. Especially if you are the financial breadwinner, consider how your loss of income would affect your family.
The death benefit can help your family cover the costs of your funeral. Funerals can get incredibly expensive, don’t let your family foot the bill. In Canada, the cost of a funeral can range from $5,000 to over $15,000.
The death benefit can also help your family pay off any outstanding debt. Tie up your financial loose ends, so your family won’t have to bear the burden.
Is life insurance right for you?
Life insurance can benefit most people, and since the payout isn’t taxable in most cases, you will have the peace of mind that your beneficiaries will receive the full amount they are entitled to.
The Government of Canada has extended the tax deadline for filing individual tax returns to June 1, 2020 due to COVID-19. If you’re self-employed, the deadline to file your taxes is still June 15, 2020. For full details and how it may affect you, please click here.