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Tax aspects of accessing the cash value of a life insurance policy Thumbnail

Tax aspects of accessing the cash value of a life insurance policy

Exempt life insurance enjoys many tax benefits. The death benefit under an exempt policy is tax-free. The accumulation of cash values inside an exempt policy is tax-sheltered. However, a disposition of an exempt policy can have tax consequences. When thinking about accessing a policy’s cash values, tax should not be the only consideration but may be an important factor.


Cash values within an exempt policy can be accessed by three main methods: policy withdrawals, policy loans and collateral loans. Each of these methods of accessing the cash surrender value of a life insurance policy has pros and cons.

Tax consequences of a disposition

A cash value withdrawal (a surrender or partial surrender) and a policy loan are dispositions of an exempt policy. A collateral assignment of a policy’s cash value to a lender as security for a loan is not a disposition.

At the time of a disposition, the proceeds of the disposition (PD) that are in excess of the policy’s adjusted cost base (ACB) are a taxable policy gain. This amount, if any, is reported on a T5 slip by the insurer. It is ordinary income, like interest income, not a capital gain. If realized by a corporation, this income is considered passive investment income.

Policy withdrawals

A policy withdrawal appeals to policy owners who need cash and have no intent to repay the amount withdrawn. Any amount up to the cash value of the contract can be withdrawn, but the policy will lapse if the withdrawal leaves insufficient funds available in the policy to cover policy costs. Withdrawals reduce the remaining cash value, if any, in the policy and may reduce the death benefit under the policy.

For tax purposes, a withdrawal is a surrender (or partial surrender) of a policy and is a disposition. To calculate any taxable policy gain, for a partial surrender, the PD is the amount withdrawn and the ACB of the policy is prorated based on the PD’s proportion of the entire cash surrender value. For example, if the withdrawal is 25 per cent of the cash surrender value, the ACB used in determining if there is a taxable policy gain is 25 per cent of the ACB of the whole policy. For Canadian resident policy owners, the insurer does not withhold tax at source on a partial withdrawal.

Policy loans

A policy owner who has a temporary need for cash and intends to repay the amount borrowed may consider a policy loan. Policy loans are contractual rights, so the policy contract should be consulted to ensure this alternative is available. If a contract permits, typically up to 90 per cent of the policy’s cash surrender value may be accessible via a policy loan. The cash value of the policy remains intact, but access to it is impacted by the policy loan.

A policy loan can be repaid at any time, but any outstanding loan amount will reduce the proceeds payable at death. If the policy owner is a corporation, a loan will reduce the death benefit, and thus the credit to the capital dividend account will be net of the policy loan outstanding.

Insurers charge interest on policy loans, and these loan rates are typically higher than commercial loan rates. No debt servicing is required on a policy loan, but the policy will lapse if the loan, including any unpaid interest, exceeds the cash surrender value of the policy.

A policy loan is a disposition for tax purposes. Unlike a partial withdrawal, a policy loan amount (the PD) is compared to the ACB of the entire policy. If the policy loan is less than the ACB of the policy at the time of the loan, no policy gain will arise, but the ACB of the policy is reduced by the amount of the loan. Policy loans become taxable only when the loan exceeds the ACB of the policy. The amount in excess of the ACB is a taxable policy gain and the insurer issues a T5.

Depending on what the borrowed money is used for, the policy owner may be able to deduct the loan interest for tax purposes. When borrowed amounts are repaid, they can create a tax deduction where the borrowed amount had a taxable portion (was previously T5’d) and the interest was not deductible.

Collateral loans

A collateral loan often appeals to policy owners with more significant cash values who require access to cash over a longer period of time and who have no immediate intent to repay the amount borrowed. Many financial institutions will lend money to a policy owner using a life insurance policy’s cash value as collateral security. The cash surrender value remains intact, but the policy is subject to a collateral assignment.

In general, financial institutions may lend 75–90 per cent of the cash surrender value. Should the loan’s terms and conditions (debt or interest servicing, or loan to cash surrender value margin requirements) not be met, the lender would have full recourse to force a surrender of the policy to satisfy the outstanding loan amount. Should this occur, there is a potential tax liability, as discussed above under withdrawals.

Collateral loans are generally repayable at any time. Loan interest is payable and may be tax deductible depending on the use of the borrowed funds. At death, any remaining loan balance would be repaid from the death benefit proceeds. If a corporation owns the policy, unlike a policy loan, the outstanding loan balance under a collateral loan has no impact on the capital dividend account credit to the corporation because the amount used to repay the corporation’s debt is seen as being received by the corporation as beneficiary under the policy.

Depending on a client’s circumstances, they may utilize different ways of accessing a policy’s cash values. Different tax results can arise from these choices. The policy contract should always be reviewed for specific details.

For more information, see Tax Topics: “Dispositions of Life Insurance Policies” and “Taxation of Life Insurance Policy Loans and Dividends.

See also: Advanced Sales team InfoGraphic: “Options for accessing the cash value of a life insurance policy