Buying life insurance can really help ease the financial strain on your family in case something happens to you. But it's important to understand if there are any tax rules involved. In Canada, the simple answer is that life insurance payouts are usually not taxed. Let's dive into the details.
Do your loved ones have to pay taxes on life insurance money in Canada?
Generally, the people you name to receive your life insurance money (beneficiaries) don't have to pay income tax on it. This is because life insurance payouts are treated similarly to gifts or inheritances, which are not taxed by the Canada Revenue Agency (CRA). Your beneficiaries can use this money for anything, like replacing lost income or paying off a house, without having to report it as extra income on their taxes.
What if your estate is the beneficiary?
Things get a bit more complicated if your life insurance money goes to your estate, which can happen if you name your estate as the beneficiary or if your named beneficiaries pass away before you. In these cases, the payout might be taxable, and settling the estate could involve extra costs, such as fees for accounting, legal, or executor services.
To avoid these issues, it's usually better to name specific people as beneficiaries on your life insurance policy. This way, you can dodge extra taxes and fees and make the process faster.
What about the cash value of life insurance in Canada?
Some life insurance policies, especially permanent ones, have a cash value that can be used for investment. This is a good option if you're already maxing out your Tax-Free Savings Account (TFSA) and Registered Retirement Savings Plan (RRSP) contributions every year.
If you decide to cancel your policy and take out the cash value, you'll have to pay taxes on any profit you made. Also, if your beneficiaries get any money from things like interest or dividends from your policy after you die, they will have to pay taxes on it.
If taxes are due, your insurance company will send you a T5 slip, which tells you how much you need to pay the government.
However, you don't need to report the earnings from your policy's cash value as long as they stay within the policy and under the limit set by your insurer (this limit can vary based on your policy and the law). Investments in life insurance policies in Canada grow tax-free, and most policies are not taxed until you withdraw the money.