Are Policy Loans Taxable In Canada?

With insurance, the number one, I guess, pain in the butt circumstance with this adjusted cost basis calculation is my good friend, the net cost of pure insurance. Everybody say boo. Net cost of pure insurance.

Are policy loans taxable in Canada? This is a question that comes up for us quite a lot in the line of work that we do, which is implementing the process of becoming your own banker, the infinite banking concept. The, the question on the top of everybody's lips is, are policy loans taxable in Canada? I am here with my colleague Richard Canfield. I'm Liz Lamond and we're going to explore this topic today.

Rich, the quick answer, I guess to the question is generally speaking, policy loans aren't taxable in Canada. However, there will become a point where they can be taxable and that goes down to the definition and what policy loans are considered in the eyes of the Income Tax act of Canada. So we're going to talk a little bit about that and then we're going to talk about the correlation to something referred to as the ACB or the adjusted cost basis. Now a lot of times I'm doing these videos, I feel like Chris Farley from the Center Live episodes with the guy who's always doing the quotation marks. All right, so we're going to draw out something that's referred to as the adjusted cost basis. So with a policy.

You can see that. Okay, right, Liz?

Yeah, absolutely. And just to clarify, we're talking about a whole life dividend paying participating policy. Just to clarify that that's exactly the type of policy we're talking about. We're not talking about other types of policies here.

Great, thank you, Liz. Perfect. So the adjusted cost basis, it kind of rises and goes up and up and up and up with a policy. Eventually, if you have a policy that's designed.

With high cash accumulation, it gets very efficient over a period of time. And the more and more and more efficient it gets.

The better performing it is, the more cash value it generates over a long period of time. So what happens is the adjusted cost basis goes up and up and up like this. It kind of is like a hill. It reaches a bit of a peak point. And this will vary for every policy. It's going to be a little bit different for everybody based on all the different factors that are happening. So it ebbs and flows on a year to year basis based on how you interact with the policy. But across the board, essentially this is kind of what happens. Just to get a bit of a visual. Well, if you have cash value that's accumulating I'm going to pick a green line here. So cash is accumulating, it's going up and up and up and up and up. And eventually you get to a point where it's below that adjusted cost basis line. Eventually they kind of reach a point where they meet where the cash is accumulating greater than the adjusted cost basis. And anything that happens over and above this point right here, when we have what's called a disposition, okay, disposition of the policy, hopefully I spelled that correctly, then now we're going to be dealing with a taxable event in that calendar year. The key thing to be aware of here, if you're watching this, there's many things that you can do about that taxable event when it takes place, or if you know that that's going to take place. Because part of the important thing that as Canadians we need to do is we need to start getting educated and understand where do our tax issues lie on a regular annual basis. And they change over your lifespan as you make more income, as your assets adjust, you sell assets. There's all these moving parts that happen in a given 12 month period from January 1st all the way to December 31st, which is the tax year where you're going to have a varying amount of taxable events that happens throughout any human being's life. So you always need to be mindful and diligent about what's happening on an annual basis. So if you now know that we're looking at a possible taxable event in the future, you can navigate around that. Now the good news is there is ways where Canadians can access capital from their policy using collateral without any taxable event at all. There's fantastic news there. So we can absolutely do that. It's just a matter of how do you do it. So the purpose of our video today is to help explain when is there going to be a taxable event in the policy itself when you're working directly with the insurance company. And then what are some ways you can think beyond that circumstance a little bit by being armed with ammunition. Basically the power of the ammunition inside of our brain. So I'm going to bring up my share again. What I want to basically show you is when we're going to kind of how it, what happens, I guess with this taxable event. We have a disposition here and I'm just going to pick some numbers kind of out of the hat, but let's just say we have cash value at this point that's worth $500,000. Okay, that's the cash value and the adjusted cost basis at this point is $400,000. So I'll keep it very simple. Now, typically, when you're accessing a policy loan, you're going to access 90% of the cash value. Because I don't want to do the math in this video. We're just going to use the 500 and the 400 here. So we have $100,000 is the difference between them. I would refer to that as the jelly and the sandwich. So if we went and took a policy loan in this situation, or a disposition of the policy, any amount, if we went all the way up to this peak value here, anything over and above this $400,000 line would be. Would create a taxable event in that calendar year. Okay, now I'm going to paint a little picture here, Liz, and here's what I want you to kind of envision and scroll down on my sheet, and let's have some fun with some colors. We're going to pick some new colors. So we've got a timeline here. And here is January 1st. Way over here is December 31st, the calendar year. And now I'm going to pick out here, I'm going to pick April 1st.

So let's assume we took this $500,000 out and we took it right on January 1st. Have we had a taxable event yet?

No, we haven't done anything yet. Right. It's not until we cross over this December 31st point in time where if we still have that entire $500,000 out, where we would have our value above the adjusted cost basis, and we would now have to report that difference of $100,000 as a taxable event moving into the next year, because we completed the entire calendar year basically without sending anything back into the policy.

All right, can I just emphasize, Rich, at that point, that it's important to emphasize we're talking about the difference. So the 400,000 of money that's come out, that's under the adjusted cost base. That's not the part that's creating the taxable event. It's the this the difference over and.

Above anything that's over and above. You got it? Yeah. Thank you for that clarification. So we've got our 500,000 minus the 400,000 of the adjusted cost basis at that point in time. Again, the adjusted cost basis will move and adjust as we go through time. So we have $100,000 is the difference. That would be the taxable event. Now, if I started returning money to the policy and I started making a policy loan repayment and let's just say I paid down.

$50,000 of repayments that went back throughout that calendar year. Well, then the net difference would be 100,000 taxable event minus the 50,000 that went back in. So now only 50,000 would be the taxable income going into the following year. This is the next really important piece as we look at this, this next calendar year, if I continue to make repayments into the policy, which is what our mentor Nelson Nash teaches us in the process of becoming your own banker from the book becoming your own banker, you want to be a good steward of your money. You're going to be putting money back into the policy, whether it's from your earned income or from other assets, et cetera. Then you're going to get, if you do end up having a taxable event, you will get a corresponding tax deduction in a future year because you're putting the money back in. So the whole process equalizes itself. Okay. Basically, over the, over a number of years, depending on how you do it, you have total flexibility. Now the key thing is this, you as the individual, as the policy owner, you have total control over this timeline and this process. By understanding it's going to happen, you can look, okay, what else do I have going on in the taxable year? Am I selling a piece of real estate? Or I'm going to have a large capital gain? Maybe I'll take that into consideration when I'm doing these policy loans or I will receive that capital and then I will apply it back into loan and I'll get the deduction in the following year. So you'll be able to maneuver really effectively through that by having the understanding, or if you choose, you can also take that policy contract and you can collaterally assign that contract to a third party, a third party lending institution. There's ones that have set up with tools available for this very specific purpose. And because we're now offloading it to away from the policy itself into the third party. There's no taxable event in that situation. So that's what a lot of Canadians will do. However, we want to focus on educating people to be in a position where they don't need to have to choose using a third party lender in Canada if they don't want to, that option is available for many people, it's the route they'll go. But if you've been using the policy throughout the growing years of your lifespan and you've been acquiring other assets, cash flow producing assets, Then now you may not need to make that collateral assignment happen. So it's about how we think about interacting with the policy.

Really important that you work with a tax professional who can look at this with you as you plan your the way that you're going to use your policy loans. So we're not providing tax advice here, we're just telling you how the policy works with regard to loans and saying these are things that you need to think about when you're making the plan with your tax professional.

This is in general, broad terms, understanding what increases the adjusted cost basis and then what decreases the adjusted cost basis. So now this comes out of, if anyone wants to have a really good night's sleep and you want to read through section 148 of the Income Tax Act, I would encourage you to go do that. There's a lot of really great, obnoxiously complicated information there. But what we're referencing is section 148 of the Income Tax Act. So specifically subsection 9, where it talks about the adjusted cost basis and how this formula is created. So this is an oversimplified version of it. There's more mechanics in there, but this gives us the really broad strokes of what increases. So on this side we have things that increase the adjusted cost basis. So it makes it go up and up and up and things that decreases what makes it go down. So one of the key things is the premiums paid on a policy. Now it says this, this varies G1, G2, G3, not to get complicated, but that's basically just different generations of policies over the years in Canada. And then we have here policy loans or repayments. So it's not justified here, but it's repayments on policy loans, basically gains required to be in the policyholder's income. So example, if you had that taxable event like I talked about, let's just say we use my $100,000 example. You had $100,000 taxable event. Well, that'll actually add to the adjusted cost basis. So now when you're returning capital and stuff, you're going to get that corresponding deduction. And when you have dividends on a policy and they are used specifically towards purchasing a premium or paid up insurance, which is what we recommend, then that can also add to the adjusted cost basis. Now what decreases these things? Well, the biggest thing that decreases it is a disposition. So a disposition means money coming out of the policy. Well, one of those things is a policy loan. So as of 1978, anything that's a policy loan after that is considered a disposition. Now, the key thing here is the reason this happens. It's important to understand why is this taking place? Well, the way that policy loans are identified in the Income Tax act of Canada is basically they're viewed as an advance. They're not a true loan. In the format of what we think about a loan, if we go to a third party lender, really what they are is they're in advance on an entitlement due to the policy owner. It's basically like you're using the death benefit like a credit card. It's like, okay, hey, I'm going to take an advance on my future death benefit right now. And because they're an unstructured loan. Unstructured loan meaning there's no requirement for anyone to repay. Liz, isn't that one of the best things about policy loans?

Absolutely.

You know, I'm sure you've been able to have the experience of like, yeah, maybe I'm not going to send a policy loan in this month. That's right. Right. You know, you want some real estate? There's been some times when you've had to like take a policy loan to go do a repair on a piece of real estate, right?

Yeah.

You ever had a vacancy?

Yeah, absolutely. And I want the flexibility to be able to pay it back. People have had tenants not paying for a month or two and all of those flexibility options are available and it doesn't cause any stress because I get to choose exactly when I make that payment back.

It's a beautiful thing. So the unstructured loan is one of the core key advantages of the policy loan now. But because it's an advance on this policyholder entitlement of the future death benefit. The viewpoint, Basically there's a CRA technical thing that happened in like December of 1984. It's because it's not a commercial loan in the status of a normal commercial loan. So that's why eventually you can have this taxable occurrence. And so as soon as the adjusted cost basis starts to hit that kind of apex level then starts to decline. Well, the next thing we would want to talk about or identify is why does it hit that peak level kind of like a hill, and then start to go back the other way. This is really, really key thing to understand for people with insurance. The number one, I guess, pain in the butt circumstance with this adjusted cost basis calculation is my good friend, the net cost of pure insurance. Everybody say, boo. Net cost of pure insurance.

So all it really is is a calculation about where the cost of the death benefit that they're servicing when they expect to pay it is. So basically what happens is it goes up and up and up and up and rises kind of like a hockey stick. And so as that goes up further out towards the end of life, where the technical actual cost to deliver a death benefit from the life insurance company is at its highest point, well, it has an inverse effect to the adjusted cost basis. So the net cost goes up and then the adjusted cost basis starts to kind of go back against it. So the end result is there's a lot of complexities with life insurance. You have total control when you have par whole life and you can access policy loans. At some point in time, there will be a taxable vent in a policy loan if you're doing it directly with the life company. But there is a way to do it where you don't have that taxable event. So a lot of good complication that we just went over there. Liz, hopefully I didn't bamboozle everyone too much, but in your words, how would you summarize everything we just covered today?

I think it's important to understand that what we're talking about with these events is certainly not at the start of your policy. This is something that may occur later on in your policy rather than immediately. So people don't need to too worried about understanding this in great detail. And because it's something that will continue to become something that you're coached on. So working with a really great coach that can talk to you about what the strategy is as your policy changes, in conjunction with your tax professional as well, so that you can make appropriate plans. And I think also just understanding that the policy loan, I think we talked about how it's a lien against the death benefit. However, it's important to understand that it's when you're accessing a policy loan, your money continues to compound inside the policy. So we're not taking a policy loan and disrupting that compounding of your money, even though it is a lien against. It's the insurance company's money that we're using to create that event. And so when you're putting it back in, you're also putting back into the.

Pool of the insurance company your capital, which is the cash value of the policy. And that's the representation of the future death benefit. It's the net present value of the future death benefit. Well, it has to continue rising no matter what, because if you're still taking air into your lungs, you're still breathing cash has got to be added into that policy because it's got to keep growing. The insurance company is on the hook to continue growing that towards equaling the end objective, which is the future death benefit at age 100. So you have constant cash accumulation, you have liquidity and access using the life insurance company's money by pledging collateral. Or you can collaterally assign with a third party lender. That's an option that's available for all Canadians on a permanent insurance policy. There's times when it may make sense giving a person's unique situation to do one or the other. Again, it's all about knowing what's going on in your life and having a coach who understands the mechanics of these options and when it makes sense to do one or the other. And so that's why we can't stress enough the importance of good coaching and being familiar with some of these rules. Because if you're unfamiliar with these rules, a person could end up actually in hot water. You know, we make a, you know, Nelson Nash used to say people will take a little bit of information and they will jump to an absurd conclusion. Like if you watch this video and only watch the 32nd bit where I said, oh, yeah, there's a point where you might have a taxable policy loan, but you didn't take into consideration all the other things and how you can, you can maneuver it and you can have total control over adjusting it. You don't just want to have a bite of the sandwich, you want to eat the whole sandwich.

I'd encourage you to re watch this video, if for no other reason, to see Rich's drawing again. But these are, these are concepts that are important to take time to review because there's a lot of information that we've packed in here so that you have an opportunity to understand all the complexity of it and the importance of having someone who can walk you through this process.

Make sure you take a look at some of our additional videos. We got another playlist right next door you can check out and keep your financial life active. Make sure you be hungry to learn and we encourage you to keep learning. We've got a ton of great content out there.