For many Canadians, life insurance is a key part of their family’s financial safety net. A common worry is, “Will my family have to pay tax on the payout?” In most cases, the answer is simple and reassuring, which is that your life insurance benefit is usually paid out tax-free.
Key Takeaways
For most Canadians, the answer to “Is life insurance taxable in Canada?” is straightforward:
- Death benefits paid directly to named beneficiaries are usually tax-free.
- Tax can appear when:
- No beneficiary is named and the money flows through your estate.
- Interest or investment income is earned on top of the death benefit.
- You cash out or heavily borrow against a permanent policy’s cash value.
The Tax Treatment of Life Insurance Death Benefits in Canada
For most Canadians, the answer to is life insurance taxable is a clear no. When the insured individual passes away, the death benefit which is the face value of the policy is paid out directly to the designated beneficiary or beneficiaries as a lump sum. The payout is not considered earned income, a capital gain or an inheritance subject to tax. Canada does not have an inheritance tax, which greatly simplifies the transfer of life insurance proceeds.
Therefore, when reviewing the query is a life insurance payout taxable, the recipient is generally not required to report this amount on their T1 personal income tax return. This tax-exempt status is the single greatest advantage of life insurance as a wealth planning tool, allowing you to transfer significant wealth to the next generation or provide immediate liquidity without the CRA taking a slice.
Example:
Sarah has a $500,000 life insurance policy and names her spouse, Mark, as beneficiary. When Sarah dies, Mark receives the full $500,000. He does not pay income tax on this amount and does not have to include it on his tax return.
When Taxes Can Show Up
While the death benefit itself is usually tax-free, there are a few situations where tax can come into the picture. These are the main ones to watch for:
- No beneficiary
- Interest earned on top of the death benefit
- Cashing out permanent life insurance (cash value)
Understanding these at a high level is often enough to avoid costly surprises.
1. When Your Estate Is the Beneficiary
If you do not name a beneficiary or all your beneficiaries have died before you, the death benefit is paid into your estate. The benefit is still not “income” in the usual sense, but running it through the estate can create extra costs and delays.
Here is what can happen when the estate receives the money:
- Probate: The full amount may be subject to provincial probate fees.
- Creditors: Estate creditors may have access to the funds before your beneficiaries do.
- Delays: It can take months or even years for the estate to be settled and for money to reach your family.
Example:
James has a $300,000 policy but never updated his beneficiary. When he dies, the $300,000 goes into his estate. The estate must pay probate fees and clear debts before his children receive what is left, and the process takes many months.
Simple Action Step:
Always name at least one primary beneficiary and ideally, a backup (contingent) beneficiary. Review your beneficiaries after major life events like marriage, divorce or the birth of a child.
2. When Interest on the Payout Is Taxable
The core death benefit is tax-free, but any investment income earned on that money after the insured person dies can be taxable to the recipient. This usually shows up in situations like:
- The insurer holds the funds for a period of time and the amount earns interest.
- The payout option chosen includes interest on top of the death benefit.
In these cases, the extra interest or investment income is taxable in the year it is received, even though the main death benefit is not. The insurer is legally obligated to track this amount and will issue a T5, Statement of Investment Income slip to the beneficiary. This investment income must then be reported on Line 12100 (Interest and other investment income) of the recipient’s personal tax return and is taxed at their marginal rate. This distinction is the main nuance when discussing insurance payouts taxable in Canada as it is the earnings on the payout that are taxable, not the payout principal itself.
Example:
Lena’s policy pays a $400,000 death benefit. The insurer holds the money for several months and it earns $2,000 of interest. Her daughter receives $402,000 in total. The $400,000 death benefit is tax-free, while the $2,000 of interest is taxable investment income on her daughter’s return.
3. Cashing Out Permanent Life Insurance (Cash Value)
This is a critical area for anyone wondering is the cash surrender value of life insurance taxable in Canada. Permanent life insurance policies, such as whole life and universal life, can build cash value over time. This internal cash accumulation is tax-deferred, meaning you don’t pay tax on the growth until you access it. However, if you decide to cancel (surrender) the policy or take large withdrawals, you trigger a taxable event on any investment gain.
The CRA defines this taxable gain using a simple calculation:
Cash Surrender Value − Adjusted Cost Basis = Taxable Gain
The Critical Concept: Adjusted Cost Basis (ACB)
The Adjusted Cost Basis (ACB) is the tax value of your policy. It represents the portion of the cash value you can receive tax-free, as it’s money you contributed with after-tax dollars.
The ACB is a highly technical figure, which is why your insurer tracks it for you. It is roughly calculated as:
Total Premiums Paid − Net Cost of Pure Insurance (NCPI) = ACB
The Net Cost of Pure Insurance (NCPI) is the internal charge for the actual death benefit coverage, and it increases as the insured person ages. Because the NCPI constantly reduces your ACB over time, older policies often have a lower ACB. This means that if you surrender a policy held for decades, the ACB may be close to zero, and nearly the entire cash value will be considered a taxable gain.
Your Action Step: You do not need to calculate this yourself. Before surrendering a policy, always ask your advisor the question, “What is the policy’s current ACB, and how much of the cash surrender value would be taxable?”
Example:
After 20 years, Priya decides to cash out her permanent life policy.
- She receives $50,000 from the insurance company (CSV).
- The insurer confirms her Adjusted Cost Basis (ACB) is $30,000.
- The $20,000 difference ($50,000 – $30,000) is treated as taxable income that year, and the insurer will issue a T5 slip showing that amount.
Policy Loans and Using Cash Value
Many permanent policies allow you to access cash value without fully cancelling the policy. The tax treatment here is more technical, but the high-level ideas are:
- Policy loans: Borrowing against your policy’s cash value is often not taxable right away, especially when the loan is within the amount you have effectively paid in (your ACB).
- Large loans or withdrawals: If what you take out is more than what you have put in (after adjustments), the excess can be treated like a partial surrender and may create taxable income.
Because this area is more complex, it is wise to check with your advisor before taking large loans or withdrawals from a permanent policy.
Business Owned and Advanced Tax Strategies
Business owned life insurance have their own set of tax rules, such as how death benefits can credit a corporation’s Capital Dividend Account (CDA). These strategies can be very effective for owners of corporations but are more specialized.
If your company owns a policy or you are considering using life insurance as part of a corporate or advanced estate plan, it is best to work with both an insurance specialist and a tax specialist who understand these rules.
Are Life Insurance Premiums Tax Deductible?
For most individuals, life insurance premiums in Canada are not tax deductible. The trade-off is that the death benefit is usually received tax-free by your beneficiaries.
In some business situations, a portion of the premium may be deductible when a policy is used as collateral for a loan taken to earn business or investment income, but this is a narrow and technical exception. The amount deductible is limited to the lesser of the premium paid and the Net Cost of Pure Insurance (NCPI).
If you think you might fall into this category, obtain specific advice before claiming any deduction.
If you are unsure how your specific policy would be treated or you are thinking about cashing out a policy, speak with your advisor. Ask them to explain, whether any tax would apply and how to avoid unnecessary surprises for your family.
Don’t leave the tax efficiency of your life insurance policy to chance. If you are trying to determine how much coverage you truly need or need a personalized review of your current policy structure, contact me today.
