Tax on cash value, dividends and policy loans

The shelter, and its edge

Money accumulating inside a life insurance policy that meets the exempt test in the Income Tax Act is not taxed year to year. You do not report growth annually the way you would on a non-registered investment. Insurers monitor the exempt test and will tell you if a deposit would push a policy offside.

That shelter is one of the genuine attractions of permanent insurance. It applies while the money stays inside the policy.

Taking money out is where the tax arrives, and the mechanism catches people out.

Adjusted cost basis

Everything below depends on this figure, so it is worth understanding.

Adjusted cost basis is a running tax calculation tracking what the policy has cost you against what has been taken out of it. Broadly, it goes up with premiums paid, and down with the cost of the pure insurance protection charged each year and with dividends credited.

The important consequence: adjusted cost basis falls over time. In the early years it rises as premiums go in. Later, as the annual insurance cost grows and dividends accumulate, it declines, and on an older policy it can be far below the total premiums ever paid.

That is why a policy which feels like it has barely broken even can produce a substantial taxable gain on surrender. The comparison is not against what you paid; it is against the adjusted cost basis.

You can ask your insurer for the current figure. On any policy you are thinking of touching, ask before acting rather than after.

Withdrawals and surrenders

Both are dispositions of an interest in the policy for tax purposes.

Where the amount received exceeds the adjusted cost basis, the excess is a policy gain and it is included in your income for that year.

Two features make this heavier than people expect.

It is ordinary income, not a capital gain. There is no partial inclusion rate. The full gain is taxed at your marginal rate.

It lands in a single year. A large surrender can push you into a higher bracket and affect income-tested benefits for that year.

The insurer issues a T5 reporting the amount. Surrendering a policy is covered in more detail in surrendering a permanent policy.

A partial withdrawal uses the tax rules for a partial disposition, including the applicable share of adjusted cost basis. Do not subtract the full policy cost basis from the withdrawal. Ask the insurer to calculate the taxable gain and explain any effect on coverage.

Policy loans

This is the part most commonly misunderstood.

A policy loan is not automatically tax free. Where the amount advanced exceeds the policy’s adjusted cost basis, part of it can be included in income, because the tax rules treat a policy loan as a partial disposition in certain circumstances.

How much depends on the policy’s history: premiums paid, insurance costs charged, dividends credited and any prior transactions. Two policies of similar size can produce quite different answers.

Repaying a policy loan can produce a deduction in the year of repayment in some circumstances, which partially offsets the earlier inclusion.

Ask the insurer for the projected taxable amount before taking a policy loan. It is a specific question they can answer, and it is the one people forget to ask. See policy loans and collateral assignment.

Collateral loans from a bank

Generally treated differently, and this is why the structure is often preferred.

Borrowing from a bank, with the policy assigned to the lender as security, is a loan rather than a disposition of an interest in the policy. It does not by itself trigger the same income inclusion a policy loan can.

The trade-offs are that a lender has to agree, the terms are the bank’s, and the arrangement is more involved to set up. In some circumstances the interest may be deductible and there are narrow conditions under which premiums on a collaterally assigned policy may be partly deductible, both of which need an accountant.

Dividends

On a participating whole life policy, dividends are generally not taxed as they are credited, which is part of the appeal. They do reduce the adjusted cost basis, which increases the taxable portion of any later withdrawal or surrender.

The exception is dividends left to accumulate on deposit with the insurer. Interest earned on those is taxable each year and is reported annually. It is the least tax-efficient of the dividend options for that reason. See participating policies and dividends.

Death is different

None of the above applies to the death benefit. A benefit paid to a beneficiary on death is generally received without income tax, whatever the policy’s adjusted cost basis was. See is the death benefit taxable.

That difference is itself worth noting when weighing whether to take money out of a policy during your lifetime.

Take this to an accountant

This page describes the mechanism. It cannot tell you what any transaction would cost you, because that depends on figures only your insurer holds and on your own tax position.

Before withdrawing from, surrendering or borrowing against a policy, get the adjusted cost basis from the insurer and take it to an accountant. Corporate ownership makes it more complicated again. Rules also change, and this page is orientation rather than advice.