Many insurance advisors are familiar with the taxation of life insurance products. But living benefits products – critical illness and disability insurance – may be less familiar. This article will provide a primer on the tax treatment of these living benefits products.
To start, living benefits products are not life insurance. They are considered accident or sickness insurance. There is some uncertainty about this characterization where return of premium on death (ROPD) is added as a rider. The CRA has said that adding ROPD may well make these products life insurance. The industry takes the view that merely adding ROPD as a rider to a living benefits product does not make it life insurance. Living benefits can also be a rider that is added to a life insurance policy. In this situation the policy is clearly life insurance and is governed by the tax rules for life insurance policies. In this article, we’ll talk about living benefits products that are not part of a life insurance policy.
Critical illness insurance
Critical illness insurance provides a lump-sum benefit upon surviving a specified period after diagnosis of a predetermined serious, life-altering illness or medical event. These lump-sum benefits should not be included in the income of the recipient/owner if the policyowner is an individual. This treatment is logical since premiums are personal living expenses paid for with after-tax dollars, and insurance benefits are ordinarily not deemed “income” for tax purposes. No provision in the Income Tax Act would expressly include such benefits in the individual's income.
When an individual pays the premiums for a critical illness insurance policy, the premiums are generally not deductible from the individual's income because they are a personal expense. Alternatively, critical illness insurance can be part of a group sickness or accident insurance plan offered by an employer to employees. Where this is so, the premium paid by the employer is deductible to the employer and included in the employee’s income as a taxable employment benefit. If a critical illness arises, the employee receives the critical illness benefits tax-free.
A critical illness insurance policy does not qualify as a “private health services plan” as defined in the Income Tax Act since the lump sum is not required to be used to cover hospital or medical expenses. However, the individual may use the proceeds received to fund medical expenses. Certain medical expenses (listed in the Income Tax Act) are eligible for the medical expense tax credit. Having critical illness insurance to pay these costs does not preclude the individual from claiming the medical expense tax credit for eligible expenses they incur.
As accident or sickness insurance, return of premium features on death, expiry, early termination or after a term of years without claim should be received tax-free as a benefit under an accident and sickness policy.
Where a corporation receives critical illness insurance benefits, even though they are tax-free, this does not create a capital dividend account credit since critical illness insurance is not life insurance.
A disability insurance policy generally provides a benefit on a periodic basis to an individual if they become disabled and their ability to earn income is compromised. Disability insurance products are generally designed to help individuals meet their income needs so they can concentrate on recovering from their disability and return to their normal lives. As with critical illness insurance, premiums for disability insurance policies are not deductible from an individual’s income because they are considered personal living expenses. And since the premiums are paid with after-tax dollars, the insurance benefits are ordinarily not deemed “income” for tax purposes and thus the benefits are not subject to tax.
Disability insurance can also be provided as an employee benefit. In general, this is a deductible expense to the employer. Where disability insurance that provides for benefits on a periodic basis is offered by an employer to employees as part of a group sickness or accident insurance plan, the premiums are not included in the employees’ income but disability income received under the plan is taxable to the employee. This exemption for an employer’s contribution to a disability plan for its employees applies only to a group insurance plan. So, if this insurance were provided for a single employee, the premium would be included in the employee’s income and any disability income benefits payable would not be taxable when received by the employee.
If the employee pays the premiums under a disability insurance plan, disability benefits would be tax free. Care must be taken to ensure all the premiums are paid by the employee. If the employer pays any premiums (with a reduction for any premiums paid by the employee) the plan benefits would be taxable. Premiums paid by payroll deduction are considered paid by the employee.
Disability and critical insurance products are useful protection products that mitigate the risk of sickness or accident. They are part of a sound financial plan for any individual. An employer may also look at these products to provide employment benefits to employees. The tax treatment in the employment context will depend on the structure of the plan, that is, the owner of the plan, the payer of the premiums and the payee of the benefits.