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How is life insurance taxed?

The proceeds, or death benefit, of a life insurance policy enjoy special tax-free status. At any point other than death, however, if a life insurance policy is surrendered (cashed in), it is treated like non-capital property that is sold. If there is a gain, the gain will be taxable. While there are several factors that can have small effects on the calculation of a policy gain on disposition, the general approach is:

Taxable policy gain = proceeds of disposition – adjusted cost base

Stated in another way:

Taxable policy gain = cash surrender value – all premiums paid + all dividends declared

If a policyholder surrendered a policy that had been in force for 10 years and the cash surrender value was $10,000, annual premiums paid $500 and dividends declared totaled $1,000, the taxable policy gain would be:

$ 10,000 - $5,000 + $ 1,000 = $ 6,000

The full $6,000 would be subject to tax and the policyholder would report the $6,000 gain on their tax return in the year in which the policy was surrendered.

From a tax standpoint there are basically two types of policies – exempt policies and non-exempt policies. The savings element/investment buildup within an exempt policy is ordinarily not subject to income taxes. When purchasing life insurance it is therefore preferable to ensure that the policy is designed to meet the exemption test.

Your insurer and a financial advisor would be the best source of information and counsel in this regard.