Life Insurance is taken as a security cover by almost everyone, whether self-employed or an employee. However, when the year ends, the question that bothers a rational mind is whether you need to report your life insurance policy on your tax return. Is it taxable or tax-free?
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There are two aspects to any Life insurance, the premium amount and the amount received on the termination of the policy. The taxation of the two differs significantly. Let us discuss each in detail:
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Amount received on termination of the Life-Insurance Policy
In general, life-insurance in Canada is non-taxable under the law. This means that the beneficiaries of the policy in question will not be required to pay any tax on the amount they receive when the insured person dies. This remains true, irrespective of the value of the policy.
However, in the following unique situations life insurance is taxed:
No listed beneficiary
If a person fails to appoint a life insurance beneficiary, then the estate of the person automatically becomes the designated beneficiary. In such a case, the sum received on the death of the person will be subject to tax. A way to avoid this is to appoint a trusted beneficiary at the time of taking the policy.
If a person has taken a loan against his life insurance policy, the loan provider will recover the loan amount from the death benefit of the policy on the occasion of the death of the person. In that case, the beneficiary will have to pay taxes on any outstanding loan balance that exceeds the value of the policy.
Selling-off your Life-Insurance Policy
Four provinces in Canada, namely Quebec, New Brunswick, Nova Scotia, and Saskatchewan, allow you to sell your life insurance policy to another person.
In this case, the buyer of the policy will receive the premiums and the death benefit. The money you get from selling your policy may be taxed. The taxable amount will depend on the type of policy, the premiums paid, the amount you received from selling it, whether there was any cash value, etc.
Premium paid on Life-Insurance Policy
1. A life insurance policy that is owned by a shareholder, but the premium is paid by the corporation:
In such a case, the premium is treated as a shareholder benefit and represents income to the shareholder.
The premium is not deductible by the corporation; unless the shareholder is also an employee. The premium is paid for the shareholder in their capacity as an employee and the premium is a reasonable business expense.
The death benefit is received tax-free by the shareholder’s beneficiary.
2. A life insurance policy that is owned by an employee, but the premium is paid by the employer:
The premiums are treated as taxable income to the employee.
The employer may deduct the premium paid against business income as long as the premium represents a reasonable business expense.
Death benefits are paid tax-free to the employee’s beneficiary.
3. Key management personnel (KMP) insurance policy that is owned by the employer, and the beneficiary of the policy is the KMP himself who may either be an employee or a shareholder:
The premiums are not deductible for the employer.
There are no tax consequences to the insured person (employee or shareholder).
The insurance benefits are paid tax-free to the employer, who is the beneficiary in this case.
4. Group term-life insurance: If the employer provides term life insurance cover for his employees.
The employer may deduct the premium paid against business income, as long as the premium payments are a reasonable business expense.
The employee must include the premium payments in income and is taxable in his hands.
The employee’s beneficiary receives the death benefit tax-free.
5. Charity as beneficiary: If an individual takes a life insurance policy on his own life, pays the premium on it, but names a charity as beneficiary;
There is no deduction for any premium paid by the individual.
The death benefit received by the charity is treated as a donation made immediately before the insured person’s death.
A tax credit is available on the insured person’s income-tax final return for the year of death.
6. Policies used as collateral security for a loan: If the policy owner assigns a life insurance policy to a financial institution as collateral security for a loan taken by him.
The policy owner may claim as deduction whichever is lower – the premium he continues to pay or the net cost of pure insurance (NCPI). This amount is prorated based on the loan amount outstanding throughout the year divided by the policy’s death benefit receivable.
For premiums or NCPI to be deductible, at least a portion of the loan interest must also be deductible. Besides, the loan should have been taken from a ‘restricted financial institution’ defined under the Income Tax Act.
Generally, the policy owner can adjust the premium as a deduction only against certain types of income, normally business income or property income. This is because the funds borrowed against the policy must be used to earn income from business or property.
In general, the premium paid by an individual on his life-insurance is not deductible from his income. Thus, it is considered a taxable benefit.
However, the sum received on the termination of the policy, i.e., the death benefit is completely tax-free in the hands of the beneficiaries. They can enjoy the receipts without needing to pay a portion as taxes. Note that this is the general rule subject to the exceptions stated in the above article.
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