How to Avoid Inheritance Tax on Life Insurance?

Inheritance tax can be avoided on life insurance policies by ensuring the policy does not trigger a taxable event. The death benefit needs to be claimed on time and paid to a beneficiary, not the estate.

Continue reading to understand how inheritance tax works and how specific situations trigger taxation on life insurance payouts, as well as how you can avoid inheritance tax on life insurance payouts.


How Inheritance Tax Works

Inheritance tax is a fee placed on the amount that an individual makes from inheriting assets, both physical and financial, from the death of another individual. This tax is more common in the United States than it is in Canada.

This is because the Canada Revenue Agency looks at all the assets of an estate before distribution and deducts any taxes from the estate. By the time assets are released from probate, taxes are already taken out, and there is no need to tax a second time for inheritance.

While it is uncommon for life insurance to be taxed once claimed, it is not unheard of. There are a few scenarios to look out for and a few ways to prevent inheritance tax on life insurance.


Life Insurance and Inheritance Taxes

In most cases in Canada, beneficiaries are not subject to inheritance tax. While the way that the Canada Revenue Agency handles estate taxes plays a major part in this, it also relates to how life insurance companies handle the payouts.

When a customer buys a life insurance policy from a company they are creating a contract between the life insurance company and the beneficiary. Under this contract, the company is required to pay the beneficiary in the event of the death of the insured.

Because the money is paid directly from the life insurance company to the beneficiary it does not pass through the estate of the deceased, and the death benefit is never considered an estate asset. By paying out this way, the beneficiary can receive the funds without any tax requirement.


Situations Where Beneficiaries May Be Taxes on Life Insurance

There are situations where a beneficiary may need to pay taxes on life insurance, but these are not related directly to inheritance. The taxes that are taken out either relate to the growth of the death benefit after the policy is “claimed” or the unlikely (and ill-advised) instance when a policy filters through the estate of the deceased.


Delayed Policy Payout

In most cases, the death benefit is paid to the beneficiary immediately upon death. Any aspects of the account gaining interest cease, and the amount at that time is locked in.

In some situations, the beneficiary can opt to have the life insurance company hold onto those funds for a specific period. During this time the policy continues to grow, and it exceeds the amount it was at when the insured died.

This situation is taxable because the growth occurs after the time of death. The beneficiary is responsible for taxes on interest made during this rest period, and the insurance company will provide proper paperwork indicating what is owed.


Death Benefit Paid to Estate

The death benefit of a life insurance policy is most often paid to a beneficiary but it can be assigned to go inter the estate of the insured if there is no beneficiary named or the beneficiary dies before the insured.

If the death benefit is paid to the estate instead of the insured then it goes through the probate process along with every other asset, and taxes are paid depending on this amount.

This is not recommended for a few reasons. If you know who you want to act as the beneficiary (or beneficiaries) of a policy then they are able to receive the funds much faster with a direct payout from the insurance company, and the funds are not taxed.

Having the death benefit go through the estate also increases the value of the estate by a significant amount, and it leads to higher estate taxes on the policy and other assets.


Ways to Avoid Inheritance Tax on Life Insurance

The easiest way to avoid tax on life insurance payouts is to ensure that the money is not put in a taxable position.

If you can, make sure the beneficiary understands that deferring the payout of a death benefit will incur taxes and that they need to make a decision that is best for their situation.

Beyond this, policyholders need to ensure that a proper beneficiary is named and keep the beneficiary updated in major life events like death or divorce.

Anyone who is not a citizen of Canada should also understand that taxes are handled differently in the United States, and transferring the policy when possible is a way to avoid estate or inheritance taxes.


Ensuring a Proper Beneficiary is Named

As previously mentioned, a death benefit that is paid to the estate is subject to estate taxes that are taken before estate assets are distributed. Depending on the size of the policy, this can also cause the estate taxes to increase.

For the most seamless transfer of funds, a policyholder needs to name a beneficiary. The policyholder should also make sure that the beneficiary is updated in the case of major life events, such as death or divorce.


Transfer United States Accounts to Canada

Estate and inheritance taxes are most common with those that:

  • Are United States Citizens
  • Have dual citizenship
  • Hold a green card
  • Are deemed a resident of the United States


Final Thoughts

It can be difficult to navigate topics like inheritance tax and life insurance policies on their own, let alone when the two interact. For help understanding how you can avoid inheritance tax on life insurance policies contact Sim Gakhar.

Not only will you have direct answers to your questions, but a conversation with an experienced life insurance and investments advisor will point you in the right direction.


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