Are Life Insurance Proceeds Part of Taxable Estate?

If you have named at least one living beneficiary on your life insurance policy, then the proceeds are not a part of your taxable estate. Proceeds become taxable when you have no living beneficiaries or if you have purposefully named your estate as your life insurance beneficiary.

This article will break down both options above and how proceeds are (or aren’t) taxed in each scenario. If you’re left with any questions, please reach out to insurance agent Sim Gakhar for further details.

When Are Insurance Proceeds Separate from an Estate?

In Ontario, insurance proceeds are separate from an estate when given directly to a beneficiary. When you sign up for a life insurance policy, you are asked to fill out a beneficiary form declaring who will receive the death benefit upon your passing. If you accurately fill out this form, your proceeds are listed separately from your estate.

That beneficiary must be alive to receive the insurance proceeds when you die. If so, they will receive the death benefit in its entirety, and this is not taxable under Canadian law.

As an example, let’s say John had a life insurance policy with a $100,000 death benefit and listed his daughter Sue as the sole beneficiary. Upon John’s death, Sue would receive the $100,000 in full and none of it would be subject to income taxes.

Exceptions

Exceptions occur if the policyholder has an outstanding loan or withdrawal from the cash value component of their policy. Permanent life insurance policies, such as whole life insurance, include a cash value component that accumulates with each premium payment.

The policyholder has the option of taking out a personal loan through the insurance company, using this cash value as collateral. Some policyholders may choose to do this because of the lower interest rates offered by these types of loans.

Although the whole life policy has cash value as collateral, these loans must also be paid back to avoid penalties. If the loan isn’t paid back, the amount owed plus interest can be deducted from the death benefit.

Let’s look back on John’s life insurance policy with that $100,000 death benefit. Now, John also had $40,000 in the cash value of this policy and decided to take out a loan for this full amount while he was alive.

John then passed away unexpectedly, still leaving his daughter Sue as the sole beneficiary. Sue would receive the death benefit, minus the $40,000 loan owed and any interest owed.

When Are Insurance Proceeds Part of an Estate?

Insurance proceeds become a part of your Ontario estate if you outlive your beneficiaries, don’t name any beneficiaries, or name your estate as your beneficiary.

In the first scenario, you have named beneficiaries but they have either died before or with you. The latter case may occur during a natural disaster or a vehicle accident.

The second scenario occurs when individuals are unsure who they want to name as their beneficiary. Instead of deciding on one individual or more, they tend to put the form to the side and bypass it entirely.

This may also happen if someone has recently surpassed an important milestone, such as a marriage, divorce, or birth/death of a child. This is one reason that Sim Gakhar and associates always recommend reviewing your life insurance policy annually, at the least.

Finally, some people choose to purposefully name their estate as their sole beneficiary. They may believe that this simply moves their death benefit under the requests of their living will, which is not the case. Others may designate the estate as their beneficiary to ensure their debts are paid before dispersing the rest of their assets to their heirs.

What Estate Taxes Can Affect Insurance Proceeds?

In all three scenarios above, the death benefit proceeds from your insurance policy go to your estate. This makes the proceeds eligible for certain estate taxes.

The largest tax incurred comes from naming a legal estate executor, called a probate fee. Estates are required to have an executor, which is the person in charge of distributing your assets according to your will if you have one.

The probate fee depends on the total value of your estate, which is determined in Ontario Courts. Your life insurance proceeds count towards your total estate value, and the fee will be paid by your estate, which means a portion may come out of the insurance proceeds.

Other taxes that can be charged include taxes for retirement plan withdrawals, the deceased’s last income tax return, and capital gains tax if the deceased owned any property upon their death.

After all taxes and debts are paid, the remainder of the estate and insurance proceeds will be distributed to beneficiaries listed on a will. If there is no will, they will be distributed according to Ontario law.

Who Should You Name as Your Beneficiary?

Choosing your beneficiary is key in determining whether or not your insurance proceeds will be taxed. Sim Gakhar and other insurance and investment professionals always recommend naming a living beneficiary on your life insurance policy.

Naming a living beneficiary in combination with creating an estate will can help you avoid hefty taxes and fees, streamline the disbursement process, and make sure your final wishes are respected.

For those who plan to name their estate as beneficiary because they want to ensure their debts are paid before the remainder goes to their heirs, consult with Sim Gakhar on other options before doing so. Sim will discuss possible alternatives that could meet your goals while protecting more of your assets from unnecessary taxes.

Who Can Help You Set Up Your Life Insurance?

When managing your estate and life insurance policies, a little professional guidance can go a long way. You’ll want to speak with someone who has experience in both life insurance long-term investments. If this is your case, Sim Gakhar has both the experience and credentials you are looking for.

Don’t leave your life decisions up to chance or the internet – speak with a certified professional today to plan a more secure tomorrow.