There are tax implications of accessing a life policy’s cash value.
The impacts of COVID-19 on our economy are far reaching — businesses have been forced to temporarily and, in some cases, permanently close their doors, and many individuals have been put out of work. As such, these events have likely thrown a curveball in your client’s cash flow and overall financial plans, and they may be looking at ways to generate cash to fund necessary expenses.
One potential source of cash could be the cash surrender value (CSV) of a permanent exempt life insurance policy.
There are three main methods to consider for accessing cash values within an exempt policy that do not involve a full surrender of the policy: cash value withdrawals, policy loans, and collateral loans. Both a cash value withdrawal and a policy loan will result in a disposition of an interest in an exempt policy. On the other hand, a collateral assignment of a policy’s cash value to a lender as security for a loan is not a disposition.
Where there is a disposition of an interest in an exempt policy, there can be tax consequences.
At the time of a disposition, the general tax consequences are the proceeds of the disposition (POD) that are in excess of the policy’s adjusted cost basis (ACB) results in a taxable policy gain. This policy gain, if any, is reported on a T5 slip by the insurer. Although it is called a policy gain, it is NOT a capital gain and is treated as ordinary income (like interest income) to the recipient. If realized by a corporation, this income is considered passive investment income, and for private corporations is subject to the refundable tax regime.
When one is considering accessing a policy’s cash value, it’s important to consider several things in addition to the tax implications. Let’s examine the positives and negatives of the three main methodsof accessing the CSV of a life insurance policy, including the different tax rules that apply.
Policy Withdrawals
A policy withdrawal appeals to policy owners who have a need for cash and have no intent to repay the amount withdrawn. The process is fairly simple, with few administrative requirements. Any amount up to the cash value of the contract can be withdrawn, but the policy will lapse if the withdrawal results in insufficient funds available in the policy to cover policy costs. Withdrawals will 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 of an interest in the policy. To calculate any taxable policy gain for a partial surrender, the POD will be the amount withdrawn and the ACB of the policy will be pro-rated based on the proportion that the POD is of the entire cash surrender value.
For example, if the withdrawal is 25% of the cash surrender value, the ACB, used in determining if there is a taxable policy gain will be 25% of the ACB of the whole policy. Therefore, any time the CSV exceeds the ACB a withdrawal will result in a taxable policy gain. For Canadian resident policy owners tax is not withheld at source by the insurer on a partial withdrawal.
Policy Loans
A policy owner who has a temporary need for cash and who 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 is an available alternative.
If a contract permits policy loans, the process is fairly simple withfew administrative requirements. In general, up to 90% of the policy’s CSV 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. This means that if the policy owner is a corporation, a policy loan will reduce the death benefit, and thus the credit to the capital dividend account will be net of the policy loan outstanding.
Interest is charged on policy loans by the insurer, and loan rates are typically higher than commercial loan rates. Debt servicing is not 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, but unlike partial withdrawals, a policy loan amount (the POD) 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 policy loan. Policy loans will only be taxable when the loan exceeds the ACB of the policy. The amount in excess of the ACB is a taxable policy gain, and the insurer will issue a T5. Depending on what the borrowed money is used for, the loan interest may be deductible for tax purposes. Borrowed amounts can be repaid and create a tax deduction where the borrowed amount had a taxable portion (was previously T5’d) and interest was not deductible.
Collateral Loans
Although not always the case, a collateral loan would generally appeal 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 the CSV of the policy as collateral security.
In general, financial institutions may lend 75% to 90% of the CSV. The CSV remains intact, but the policy is subject to a collateral assignment. There are more complex administrative requirementsfor collateral loans, and fees may apply. Should the loan’s terms and conditions (debt or interest servicing, or loan to CSV 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 a surrender occur, there is a potential tax liability, as discussed earlier.
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 and is the borrower, unlike a policy loan, the outstanding loan balance under a collateral loan has no impact on the corporation’s capital dividend account credit since the amount used to repay the corporation’s loan is seen as being received by the corporation as beneficiary under the policy.
So, during these difficult times, clients who own permanent life insurance policies with cash value may have access to a much-needed lifeline. Clients considering accessing their cash value should review their particular contract to confirm available options.
(Reprinted with permission of The Institute for Advanced Financial Education
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