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13. Taxation of Life Insurance

May 23, 2025

Taxation of Life Insurance

Overview

  • Focus on Chapter 7: Taxation of Life Insurance.
  • Tax-free death benefit is a significant advantage of life insurance.
  • Taxation issues arise primarily if the policy is disposed of during the policyholder's life.

Key Concepts

Tax-Free Death Benefit

  • The death benefit is generally paid out tax-free to beneficiaries.

Actual Dispositions

  • Occurs when a policy is surrendered, transferred, or sold.
  • Tax implications can arise if the disposal results in gains.

Deemed Dispositions

  • Tax consequences without actual transfer or surrender.
  • Scenarios include:
    • Withdrawing cash from the policy.
    • Taking a policy loan.
    • Receiving dividends from participating policies.
    • Policy becoming non-exempt.
    • Policyholder dies owning a policy on another's life.

Calculating Tax Liabilities

Actual Disposition Example

  • Selling a condo analogy: Gain is calculated as the difference between sale proceeds and adjusted cost.
  • For insurance policies:
    • Proceeds of Disposition: Amount received when policy is surrendered.
    • Adjusted Cost Base (ACB): Total premiums paid minus dividends received.
    • Gains are taxable if proceeds exceed ACB.

Adjusted Cost Base (ACB) Formula

  • Pre-December 2, 1982:
    • ACB = Total premiums paid - Dividends declared.
  • Post-December 1, 1982:
    • ACB = Total premiums paid - Dividends declared - Net Cost of Pure Insurance (NCPI).

Net Cost of Pure Insurance (NCPI)

  • Total cost of insurance paid monthly from premiums.
  • Applicable to Universal Life policies.

Policy Gain Example

Background

  • $200,000 whole life policy purchased in 2003.
  • Annual premium: $2,000; Dividends received: $4,000; NCPI: $3,500.
  • Policy surrendered for $31,000.

Calculation

  1. Proceeds of Disposition: $31,000
  2. Adjusted Cost Base:
    • Total premiums paid over 15 years = $30,000.
    • Adjusted: $30,000 - $4,000 (dividends) - $3,500 (NCPI) = $22,500.
  3. Policy Gain:
    • $31,000 (proceeds) - $22,500 (ACB) = $8,500 gain.

Implications

  • Brian must add $8,500 to his income for tax purposes.
  • Tax calculated on gain exceeding the net contribution.

Conclusion

  • Understanding the taxation of life insurance policies is crucial.
  • Important to differentiate between actual and deemed dispositions.
  • Proper calculation of ACB and gains ensures compliance with tax obligations.

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