You may no longer have enough life insurance thanks to capital gains tax hike

A big tax hike just came into effect in Canada and believe it or not, it could have implications for your life insurance policy. Changes to the way capital gains are taxed could mean you no longer have enough insurance coverage, especially if you own a large asset like a family cottage.

What are the changes and what do they have to do with insurance? Keep reading to find out.

What are the 2024 capital gains tax changes in Canada?

When you make money from selling property like real estate or investments, it’s not taxed as income but rather as something called a capital gain. 

While the tax rates for capital gains are the same as the tax rates for other income, the rule up until now has been that only 50% of capital gains are subject to taxation. For example, if you had $100,000 in capital gains in a tax year, you would only pay tax on $50,000 of that income.

As of June 25th, 2024, that rule has changed. Now when you have a capital gain you will pay tax on 50% of the first $250,000, and 66.67% (two-thirds) on any amount over $250,000.

Take, for example, a capital gain of $500,000. Under the old rule, income tax would be due on 50% of that, or $250,000. Under the new rule, income tax is due on 50% of the first $250,000 and 66.67% on the remainder for a total of $291,675. That works out to about $22,000 in extra taxes for the same amount of income for a resident of Ontario.

Our calculations were made using a capital gains tax calculator. For more insight on how the changes may impact your specific case, be sure to use it for your own calculations.

What does this change have to do with life insurance?

The thing about capital gains tax is that you don’t actually have to earn income to trigger a capital gain. All you need is a “deemed disposition,” which is the Canada Revenue Agency’s (CRA) way of saying “you can’t avoid taxes by never selling something.”

There are many ways to trigger a capital gain through deemed disposition, and dying is one of them. Your estate will be expected to pay income tax on the capital gain that would have been made had those investments been sold. This can be a big problem for assets like vacation properties, which can’t be both sold and bequeathed.

Fortunately for those wealthy enough to have these problems, life insurance can help. People figured out that you can name your estate as the beneficiary of your life insurance policy, have the benefit paid out tax-free, and use it to pay the capital gains tax on any deemed disposition.

Your life insurance policy may no longer be enough to cover your estate’s taxes

If you’re among those who have life insurance in place to pay your estate’s capital gains tax on your death, the recent changes may mean you no longer have enough coverage.

Consider, for example, a family cottage. While vacation homes were once affordable for the middle class, property values have skyrocketed and can easily be worth more than a principal residence. 

Imagine a cottage bought for $500,000 that’s currently estimated to be worth $2.5 million. Under the old rules, 50% of that gain would be taxable and the estate would be charged roughly $535,000 in capital gains tax. Under the new rules, 64.6% of the gain is taxable and the estate will be charged closer to $691,000 in capital gains tax – an increase of about $156,000.

If you have a large asset like this and bought life insurance assuming the capital gain would be taxed at 50%, you may no longer have enough coverage. Speak with your financial advisor or insurance broker about the changes to find out whether you need to top up your policy to account for these changes.

No changes to tax on cash value withdrawals from life insurance

Another way life insurance can save taxes is by holding investments in the policy itself. Known as a “permanent” or, more specifically, “universal” life insurance, this type of coverage lets you pay more than the cost of insurance and invest the extra. And because there are no taxes on life insurance distributions, the whole problem of capital gains tax goes away.

A key benefit of universal life insurance is that you don’t have to die to get that extra money back out of your policy. Known as a “pre-death distribution,” or “surrender,” this action takes money out of your life insurance policy and puts it back in your pocket.

If you’re among those using a universal life insurance policy to invest, you’ll be happy to know there’s no change in the way cash value withdrawals are taxed. 

The bad news is that cash value withdrawals from life insurance are taxed as other income, not capital gains. That means you’ll pay tax on 100% of the gain from your investments – a higher overall tax bill than if the withdrawal were taxed as a capital gain.

An alternative to withdrawing cash value from your life insurance policy is to take a loan using your policy as collateral. You may be able to borrow between 75 to 90% of the cash surrender value of your policy as an alternative to cashing out your life insurance. Your financial advisor or insurance broker can help you understand your options.

The bottom line

Recent changes to capital gains tax rates in Canada don’t directly affect your insurance policy, but higher taxes on your estate could require more life insurance than you currently carry. Consult with your financial advisor or estate lawyer to find out how the new capital gains taxes could affect your estate and whether you have enough life insurance coverage to protect your assets.

Also read:

• How has COVID-19 changed the life insurance industry?
• What is the life insurance underwriting process?
• Life insurance for tax and estate planning