Note: This is part six of a series on tax and insurance.
In part one we talked about the general tax attributes of life insurance. Part two looked at transactions resulting in a policy disposition, and how the proceeds and policy gain are determined. In part three we discussed the adjusted cost basis (ACB) of an insurance policy and how it’s determined. Part four reviewed how the net cost of pure insurance (NCPI) is calculated, and its impact on an insurance policy’s ACB and the collateral insurance deduction. Part five delved deeper into the collateral insurance deduction—when it can be claimed and how it’s determined.
In this article we’ll explore how life insurance cash values can be accessed by a policyholder for emergency or investment purposes.
Premiums in perspective
Many people regard premiums for permanent life insurance as an expense to be minimized or avoided. However, in many respects the purchase of a permanent insurance policy is no different than making a long-term investment. Assuming premiums are maintained until death, the policy will pay a predetermined amount to the deceased’s beneficiaries. While the “rate of return” on the premiums depends on several variables, including the timing of death, there is a guaranteed tax-free benefit, which can exceed the returns on other types of investments.
So, what’s the problem?
Once clients get over the mental hurdle of expense versus investment, they’re often still concerned that the ultimate benefit is locked in until the death of the life insured. Thus, premiums still feel like an expense, as there’s no tangible value while the life insured is alive.
But that doesn’t have to be the case.
Most permanent policies permit the policyholder to make deposits in excess of the annual policy costs. These additional funds are invested by the insurance company, and any income earned on this policy reserve can grow on a tax-deferred basis. This represents an asset that can be accessed by the policyholder in a variety of ways. And if this value isn’t required by the policyholder, it can be used to pay premiums or cost of insurance charges. In effect, pre-tax dollars are available to fund future policy costs. That should get clients’ attention.
Accessing cash value
What if the policyholder wants to access the policy’s cash reserve, or cash surrender value (CSV), for personal or business purposes?
One popular way is to request a policy loan from the insurance company—a contractual right under most permanent insurance policies. The amount borrowed (including compounding interest) can’t exceed the cash surrender value of the policy. The interest rate on the loan (or its calculation) is also set out in the policy contract and is typically competitive with secured loan rates offered by other financial institutions. Further, a policy loan can be obtained without all the paperwork normally associated with other types of loans, and isn’t subject to regular review and renewal.
Also, a policy loan isn’t a loan in the traditional sense, as the insurance company can’t force repayment. However, if 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 on the death of the life insured, the loan will be deducted from the death benefit.
A policy loan is treated as a policy disposition. Where the loan is taken in cash and doesn’t exceed the policy’s adjusted cost basis (ACB), the only result will be a reduction in the policy’s ACB. But if a policy loan exceeds the policy’s ACB, the excess amount is taxable.
For example, assume Tasha owns a universal life policy with a CSV of $10,000 and an ACB of $5,000. If she takes a $4,000 policy loan, the policy’s ACB is reduced to $1,000. If in the following year, Tasha takes another policy loan of $3,000, there would be a taxable gain of $2,000, and the ACB of the policy would be reduced to nil. At this point she would have a $7,000 policy loan (ignoring interest), $3,000 of net CSV and the policy’s ACB would be nil.
If a policy loan is subsequently repaid and the original loan wasn’t taxable, the repayment is added to the policy’s ACB. But if any part of the loan resulted in a taxable gain to the policyholder, this amount is deductible from the policyholder’s income.
Looking at Tasha’s situation, if she subsequently repaid the entire policy loan, she would be entitled to a $2,000 deduction and the ACB would return to $5,000 (this ignores any other transactions that could impact the policy’s ACB).
It’s important to note that recent tax changes affecting insurance policies issued after 2016 typically result in such policies having a higher ACB over a longer period (see part four). This means that higher policy loans may be available, without triggering a policy gain, compared to policies issued before 2017.
It’s also possible to deduct interest payable on a policy loan used to earn income from a business or property, provided CRA Form T2210 is obtained from the life insurance company verifying the policy loan interest charged in the year.
In the next article, we’ll discuss some other common transactions involving policy loans, as well as their tax treatment.
Kevin Wark, LLB, CLU, TEP is managing partner, Integrated Estate Solutions, and tax consultant, Conference for Advanced Life Underwriting. He’s also the author of The Essential Canadian Guide to Estate Planning.