Life Insurance 101: Is Life Insurance Taxable?

You've heard that buying a life insurance policy is a great way to protect your family financially. And because you care about your loved ones more than anything, you want them to have a financial safety net in case you're not around as long as you hope to be.

But as a Canadian, you also know that any time money falls into your lap, the Canada Revenue Agency (CRA) usually shows up on your doorstep to demand a cut. So when you think about buying life insurance, here's something you might be wondering: "Is life insurance taxable? Will my beneficiary get taxed on my death benefit?"

Well, you can breathe a sigh of relief because the short answer is "no." That said, there are some exceptions.

Don't worry, though. Because below, we break down what you need to know about when life insurance is and isn't taxable in Canada.

Let's dig in!

What is Life Insurance?

To answer the question about when life insurance is vs. isn't taxable, it's helpful to tackle another question first: What is life insurance?   

A life insurance policy is designed to protect the people who depend on you financially. For most policyholders, these people are spouses and underage kids. But you might also have other people in your life who are financially dependent on you. This could include an aging parent, an adult child with special needs, or an extended family member.

When you buy a life insurance policy, you pay premiums each month to pay for the cost of your coverage. If you die while your policy is active, your insurance company will give your beneficiary a lump sum payment called a death benefit.

Your beneficiary can use the death benefit in any way they want. But most beneficiaries use their death benefit to cover expenses that the policyholder used to pay for while they were alive. These expenses might include mortgage payments, utility bills, or school tuition. Some beneficiaries also use the funds to pay for funeral expenses, which can range from $5000 to over $15,000 in Canada.

Types of Life Insurance in Canada

The tax implications of a life insurance policy differ depending on the type of policy you buy. Before we tackle our main question, let's summarize the types of policies you can purchase.

Term Life Insurance

A term life insurance policy is a policy that lasts for a fixed time period. You get to choose the length when you buy your policy.

If you die during your policy term, your beneficiary will receive your death benefit from your insurer. On the other hand, if you die after your policy expires, your beneficiary won't receive anything. (Sorry, beneficiary!)

Permanent Life Insurance

A permanent life insurance policy gives you coverage for the rest of your life. This means that your beneficiary will receive your death benefit at some point—it's just a matter of when.

Unlike term life insurance policies, permanent policies include a death benefit and a cash value. Each year, your insurer invests the cash value of your policy, allowing it to earn interest. (Keep this part in mind for when we talk about taxes on life insurance!)

Is Life Insurance Taxable in Canada?

If you're shelling out money on life insurance premiums each year, you probably want to know that it's actually going to protect your family. After all, the last thing you want is to pay for a financial safety net that's only going to get chopped in half by the CRA as soon as it falls into your beneficiary's hands.

Well, the good news is that life insurance is usually NOT taxable in Canada. (Feel free to break out into that happy dance!)

Why is life insurance usually not taxable?

Because in Canada, most financial gifts and inheritances aren't considered income. The death benefit that a beneficiary receives from a life insurance policy falls under this umbrella. As a result, it isn't subject to income tax and doesn't have to be reported on a Canadian tax return. Score!

The death benefit of a life insurance policy is tax-free regardless of the size of the policy and who you name as the beneficiary. So you definitely shouldn't skimp out on coverage just because you're concerned about your loved ones being taxed more on a larger death benefit.

The tax implications of your death benefit are the same regardless of whether you have a term life or permanent life insurance policy. In both cases, the money that your beneficiaries receive as your death benefit isn't considered taxable by the CRA. (And of course, if you outlive a term life insurance policy, your beneficiary won't receive a death benefit anyway.)

When Is Life Insurance Taxable?

As with many things in life, there are some exceptions to the tax rules for life insurance.

Here's when life insurance does become taxable in Canada:

1. You Don't Have a Beneficiary

What happens if you don't designate a beneficiary on your life insurance policy? Your estate will automatically become your beneficiary when you die. And when your beneficiary is your estate rather than an actual person, your death benefit might be taxable.

Keep in mind that if your death benefit gets paid out to your estate, it'll also increase the total value of your estate. As a result, you might have to pay out even more to the CRA in taxes when you die and the executor of your estate files your final tax return.

Because your death benefit can be taxable when you leave it to your estate, financial experts recommend naming an individual as the beneficiary on your life insurance policy. Remember that you can designate multiple beneficiaries on your policy, so you don't have to single someone out as your favourite when you choose a beneficiary (unless you want to, of course).

You also can and should update your beneficiary information as your relationships and financial responsibilities change over time. Your beneficiary information isn't set in stone when you buy your policy.

2. Your Policy Has a Cash Value

As we mentioned earlier, permanent life insurance policies include a cash value. This cash value can earn interest over the course of your policy. Unfortunately, unlike a death benefit, income earned as interest is usually taxable by the CRA. And the interest earned on the cash value of a permanent policy is no exception.

This means that if you decide to surrender your permanent life insurance policy before you die and get the cash value in return, you'll pay taxes on the amount you earned in interest on the cash value.

The cash value of your policy will also be taxable if your death benefit isn't paid out to your beneficiary right after you die. Specifically, in your policy, you can specify that your insurer should hold on to your death benefit for a certain period of time after your death before paying it out. In this case, the cash value of your policy will continue to earn interest until your death benefit is paid out. Your beneficiary will be taxed on the interest earned when they receive your death benefit.

3.  Your Policy is Loan Collateral

You can use your life insurance policy as collateral for a loan that you take out. This means that if you die, your loan provider will first get to use the money in your death benefit to pay off any outstanding balance on the loan.

If there's money left in your death benefit after this point, your beneficiary will receive the rest, and they won't be taxed on it. But if there wasn't enough money in your death benefit to pay off the loan, your beneficiary will have to pay taxes on the outstanding loan balance.

4.  You Sell Your Policy

You can legally sell your life insurance policy to somebody else if you live in Saskatchewan, Quebec, New Brunswick, or Nova Scotia. The buyer will take on the responsibility of paying the premiums and designate a new beneficiary. You'll give up all rights to the policy and any benefits you originally paid for. And in addition to this, you could get taxed on the money you make from selling your policy.

How much will you have to pay in taxes if you sell your policy? It'll depend on the type of policy you had, the amount you paid into it while you held it, the amount you made by selling it, and whether the policy had a cash value.

How Do I Report a Payout on my Tax Return?

What if you're a beneficiary and you've received a life insurance payout? What do you need to report on your annual tax return?

If you received just a death benefit without any interest earned, it's pretty simple. You don't have to report the death benefit as taxable income on your return.

However, you will have to report the interest as income on your tax return if it was received as part of the payout. The insurance company will send you a T5 slip that specifies the amount you need to include on your return. Follow the same process if you're the owner of a policy with a cash value and you decide to surrender your policy.

Good News? Life Insurance is Usually Tax-Free

No one wants to pay more in taxes than they have to. It's understandable that you might be concerned that you or your beneficiary could be taxed heavily on your life insurance policy.

Fortunately, if you're wondering "Is life insurance taxable in Canada?" the answer is usually "no."

You can give your family a financial safety net without worrying that it'll get eaten up by the CRA.