Note: This is part seven of a series on tax and insurance. Find the full series here.
In part six of this series, we explored how life insurance cash values can be accessed by a policyholder through a policy loan. In this article we’ll delve deeper into specific transactions involving policy loans and their tax treatments.
Policy loan refresher
A popular way to access the cash value of a permanent insurance policy is to request a policy loan from the insurance company. The amount that can be borrowed (including compounding interest) is limited to the cash surrender value (CSV) of the policy. Interest is charged on the loan with rates being competitive with secured loan rates offered by other financial institutions.
A policy loan isn’t a loan in the traditional sense, as the insurance company can’t force repayment. But where the loan and any accumulating interest exceeds the policy’s CSV, a portion of the loan must be repaid, or the policy will lapse. If a policy loan remains outstanding upon death of the life insured, the loan will be deducted from the death benefit.
A policy loan can be used for any purpose—for example, to provide cash to pay unexpected expenses or for investment purposes. It’s also possible to obtain a policy loan to pay policy premiums. In fact, many policies permit the insurance company to advance policy loans to pay delinquent premiums to keep the policy in force. This is often referred to as an automatic premium loan.
Tax treatment of loans to pay premiums
Unlike a policy loan taken in cash, a policy loan used to pay a premium doesn’t result in proceeds of disposition. Thus, there’s no tax reporting to the policyholder even if the loan exceeds the adjusted cost basis (ACB) of the policy, and no downward adjustment to the ACB. However, there’s also no increase in the ACB due to premium payments via policy loans. In effect, the policy loan and premium are netted against each other, and the ACB remains unchanged.
For policies issued before 2017, a subsequent repayment of the policy loan with external funds doesn’t increase the policy’s ACB. This technical glitch has been fixed for policies issued after 2016. Where a policy loan has been used to pay premiums and the loan is subsequently repaid with funds from outside the policy, the policy’s ACB will be increased. On the other hand, if the policy loan is repaid through a partial surrender of the policy, the ACB of the policy remains the same.
Policy loans and disposition rules
A second deficiency in the tax rules—this time to the benefit of policyholders—has also been corrected for policies issued after 2016. Under rules in place for policies issued before 2017, it’s possible to use a policy loan to avoid the partial disposition rules in the Income Tax Act.
These rules provide that if the policy is in a gain position (i.e., the policy’s CSV exceeds its ACB) and there is a partial surrender of the policy, a pro-rata portion of the gain must be reported. However, these rules don’t apply where a policy loan is taken in cash, where the amount of the loan doesn’t exceed the policy’s ACB. Thus, a policy loan up to the amount of the policy’s ACB can be extracted on a tax-free basis. It’s then possible to partially surrender the policy to repay the policy loan, without this giving rise to proceeds of disposition. The bottom line: by first taking the policy loan and then doing a partial surrender to repay it, the policyholder doesn’t realize a pro-rata gain on the withdrawal of funds.
However, this opportunity is no longer available for policies issued after 2017. New rules provide that where a policy loan has been taken in cash and subsequently there is a partial surrender of the policy to repay the loan, the tax results are the same as if there had been no policy loan and instead a partial surrender of the policy (i.e., tax reporting of any gain on a pro-rated basis).
Policy loans outstanding at death
As discussed in the previous article on policy loans, where a policy gain arises from the receipt of a policy loan, a deduction may be claimed by the policyholder where the loan is subsequently repaid. But there’s yet another technical issue that arises where a policy loan under an individually owned policy is outstanding at death. In these circumstances, the death benefit payable under the policy will be reduced by any outstanding policy loan. Since the policy loan has effectively been repaid through the death benefit, it might be expected that a deduction can be claimed in the deceased’s final tax return, assuming the original loan resulted in a taxable gain.
However, Canada Revenue Agency (CRA) has indicated that no deduction is available upon death of the policyholder/life insured, as in CRA’s view the beneficiary rather than the policyholder has repaid the policy. This appears to be the case even where the deceased’s estate is the recipient of the death benefit. This can lead to the very undesirable situation where a terminally ill person (or the family) may need to contemplate the repayment of a policy loan prior to death, to benefit from this tax deduction.
In the next article, we’ll discuss accessing the value of an insurance policy through a collateral loan secured by the policy’s cash value.