What tax planning strategies can be employed with life insurance payouts?

Life insurance is a powerful financial tool that offers more than just financial security to loved ones. If used correctly, life insurance can help reduce your tax liability both during your lifetime and after your death.

Not only are life insurance proceeds or death benefits not taxable in Canada, but certain policies, such as permanent life insurance, also allow you to benefit from tax-sheltered investment growth.

By implementing the right tax planning strategies with your life insurance payouts you can better protect and grow your wealth, all while maximizing tax savings!

Continue reading to learn more.

Understanding Life Insurance 

Canada has two types of life insurance policies: term life insurance and permanent life insurance

Both types of insurance serve the purpose of protecting your family financially in the event of your death. However, the two policies vary in terms of premium costs, duration of coverage, and the tax benefits they provide. 

Term life insurance offers coverage for a set period, usually 10-30 years, whereas, permanent life insurance lasts the policyholder’s lifetime. As such, permanent life insurance has higher premiums as the payout is guaranteed. On top of that, it also offers a saving component called cash value that grows as you make more and more premium payments.

Understanding Tax Benefits of Life Insurance

Now, as far as tax benefits go, both policies offer several tax benefits including:

Tax-Free Death Benefits

In the event of the policyholder’s passing, the agreed-upon death benefit will be paid out in full to the designated beneficiaries without any income tax obligations. 

Tax-Deferred Cash Value Growth

Permanent life insurance or whole life insurance includes a cash value component that grows on a tax-deferred basis until a withdrawal is made. This cash value allows for tax-sheltered growth which can be highly advantageous for high-income earners who have already maxed out on tax-advantaged investment accounts such as a TFSA or RRSP.

Tax-Free Policy Loans

The cash value of a whole life insurance policy can be used to take out a policy loan which is not subject to income tax. Having access to this type of loan is something many policyholders don’t realize although this form of loan can be a valuable source of tax-free money in times of financial need or during retirement.

Estate Planning Tax Benefits

Many high-net-worth individuals in Canada will often designate their life insurance policy as a beneficiary of their estate. This is done to help bypass probate fees as life insurance proceeds can be paid directly to the beneficiaries resulting in considerable cost savings.

Strategies to Save Money from Taxes

Now that you understand life insurance and its tax benefits, let’s look at some tax planning strategies that can help you save money from taxes.

Establishing a Trust

This is one of the go-to tax-saving strategies for high-net-worth individuals in Canada. Establishing a Trust not only helps you keep track of your life insurance policies to ensure they are current and relevant but also allows you to direct how the proceeds are to be used or distributed upon death. 

A Trust is not liable to pay income tax and offers policyholders more control over life insurance payouts and the continuity of their legacy.

Gifting Inheritance During Your Lifetime

Gifting money to your heirs during your lifetime can be immensely satisfying while providing financial advantages. 

Gifting inheritance early can help reduce the size of your estate, lowering probate costs and estate taxes which can result in significant cost savings.

Taking Out a Policy Loan

The cash value of your permanent life insurance policy can be used to take out a policy loan, which, unlike other types of loans, doesn’t have to be paid back as you are simply borrowing or withdrawing money from your existing cash value. 

The advantage of this is that as long as you are borrowing up to the adjusted cost basis (ACB) of your policy you don’t have to pay any tax.

When is Life Insurance Proceeds Taxable in Canada?

While life insurance proceeds are rarely taxable, there are some exceptions. A death benefit can be taxed depending on who receives it and how.

For example, if you have opted for your beneficiaries to receive death benefit payments in installments, the interest earned on the principal amount will be taxable. 

If there is no beneficiary named, life insurance proceeds are paid out to the policyholder’s estate which is taxed. This is why it is always recommended to name beneficiaries on your life insurance policy as proceeds paid out to the estate will be taxable.

Consult with a Trusted Life Insurance Broker

The rules governing taxes for life insurance are complex and ever-changing. The best way to determine what tax planning strategy works best for your life insurance payouts is to consult a trusted life insurance broker

Experts, such as Pat McIver, can ask the right questions to help you figure out the tax implications of life insurance and find you the coverage you need at the best possible price. 

To schedule a one-on-one meeting call now at 1-902-220-3279 or email [email protected]


Q) Are life insurance proceeds taxable in Canada?

In most cases, no! Life insurance proceeds are generally tax-free unless the beneficiary is an estate.

Q) Can you use life insurance as a tax shelter?

Yes. Permanent life insurance policies often have a cash value component that offers tax-deferred growth.

Q) What happens (from a tax standpoint) if you cash out your life insurance policy?

If you cash out your life insurance policy using a policy loan, it is tax-free. However, if the amount taken out exceeds your policy’s Adjusted Cost Basis (ACB), the exceeding amount will be subject to tax.

Q) Why is beneficiary designation essential for tax planning?

Assigning individuals, such as family members, or an entity, such as a charitable organization, as a beneficiary prevents life insurance proceeds from being taxed as part of the estate. This can ensure tax-free transfers of payouts to appointed beneficiaries.

Q) Can life insurance assist with retirement planning?

Yes, life insurance can be used to complement other retirement plans such as TFSAs and RRSPs, allowing for tax-deferred growth.