Retirement Income From a Contract and the Word Tax-Free

A participating whole life contract accumulates a cash surrender value, and a person who owns one for long enough may want to draw on that value once earnings stop. This page is about the phrase most often attached to that idea, which is that the income is tax-free, and it examines the phrase one route at a time under section 148 of the Income Tax Act. It does not explain how a structured arrangement with a lender is put together, which is set out on the insured retirement plan page, and it does not explain how a policy loan itself is taxed, which is set out on its own page.

Everything below is general information written by a licensed insurance professional. How any of it applies to a particular contract, a particular lender or a particular return is a tax question, and tax questions belong to a Chartered Professional Accountant who has the insurer's statement in front of them. Canadian Wealth Creation Centre Inc. is not authorized to give legal, tax or notarial advice and gives none here.

Is retirement income from a participating contract tax-free?

Not as a feature of the product. Value leaves a contract in retirement by one of three routes, and the Income Tax Act treats each differently. A withdrawal is taxable above the adjusted cost basis. A policy loan is taxable past that same figure. Only a collateral loan from a third party lender is not income.

The reason the three routes diverge is a single definition. Subsection 148(9) of the Income Tax Act defines a disposition of an interest in a life insurance policy, and subsection 148(1) requires a policyholder to include in income, for the year of a disposition, the amount by which the proceeds of the disposition exceed the adjusted cost basis of the interest immediately before it. Whether a route is a disposition decides whether subsection 148(1) applies at all, and that is the question this page asks three times.

Two terms carry the whole discussion. The adjusted cost basis is the running tax cost of the policyholder's interest, defined in subsection 148(9) by a formula that adds premiums paid and subtracts, among other items, the net cost of pure insurance charged each year. The cash surrender value is what the insurer would pay on a full surrender. The gap between them is the gain that subsection 148(1) reaches on a disposition, and on an older contract that gap is commonly large.

None of this concerns growth inside the contract while it stays there. That growth is untaxed year by year only because the contract is an exempt policy under section 306 of the Income Tax Regulations, and the mechanism is set out on the tax deferred growth page. Deferred is the word that applies inside the contract. What happens when value comes out is the subject here.

What happens when I withdraw part of the cash value?

A withdrawal, which an insurer records as a partial surrender, is a disposition of part of the policyholder's interest under subsection 148(9) of the Income Tax Act. Subsection 148(1) then includes in income the amount by which the proceeds exceed the adjusted cost basis of that part. The insurer reports the taxable portion, and it is ordinary income.

The proportional rule for a partial disposition sits in subsection 148(4). Where a policyholder disposes of part of an interest, the adjusted cost basis of that part is the total adjusted cost basis of the interest multiplied by the proceeds of the partial disposition and divided by the cash surrender value of the interest immediately before the disposition, for a contract issued after 2016. An older contract uses the accumulating fund in the denominator. The effect is that every withdrawal carries out a slice of the adjusted cost basis in the same proportion as the slice of value it removes.

Arithmetic, and only arithmetic, shows what the rule does. Suppose an interest with an adjusted cost basis of 40 and a cash surrender value of 100, and a withdrawal of 10. Subsection 148(4) allocates an adjusted cost basis of 4 to the part withdrawn, and subsection 148(1) includes 6 in income. Those numbers are not a contract's values and no contract behaves in round tens; they show only that a withdrawal from a contract with a low adjusted cost basis is taxable in most of its amount.

A withdrawal also reduces the contract itself. The cash surrender value falls by the amount taken, the death benefit is reduced, and a withdrawal from the paid-up additions bought with participations surrenders coverage that does not come back. Participations are not guaranteed, and a contract that has been drawn down has less on which future participations can be credited. Nothing about that route is free, and nothing about it is tax-free.

What happens when I take a policy loan from the insurer?

A policy loan is a disposition. Paragraph (b) of the definition of disposition in subsection 148(9) of the Income Tax Act says so for a policy loan made after 31 March 1978, with the proceeds measured by the loan. The practical result is that a policy loan is taxable once the amounts advanced exceed the adjusted cost basis.

The definition is short and the consequence is not. Because each advance is a disposition, each one is measured against the adjusted cost basis at the time it is made, and the insurer keeps the running account. Nothing is reported while the cumulative advances sit below that figure, and everything above it is ordinary income in the year of the advance.

That mechanism, including how the adjusted cost basis is reduced by each advance and restored by each repayment, and how the insurer reports the taxable portion, is set out on the policy loans page and is not repeated here. The wider choice between a policy loan and other forms of credit is set out on the page about a policy advance and other credit. This page adds only the point that matters to the word in its title.

The point is that a policy loan is the middle route. It is not income up to the adjusted cost basis, and it is income above it, so a person drawing a policy loan each year in retirement is drawing amounts with no income inclusion for a while and taxable amounts after that, with the boundary set by a number the insurer holds. Interest on the loan accrues to the insurer at a rate the insurer sets and can change, and an unpaid loan is deducted from the death benefit.

What happens when a lender advances money against the contract?

A loan from a third party lender, secured by an assignment of the contract, is not a disposition. The definition in subsection 148(9) of the Income Tax Act excludes an assignment of an interest in the policy to secure a debt or a loan other than a policy loan. No disposition means nothing for subsection 148(1) to include.

The reason nothing is included is simpler than it looks: a loan is not income. A person who borrows from a lender receives money that has to be paid back, and the Income Tax Act does not tax a debt as though it were a receipt. The assignment of the contract as security changes who can reach the cash surrender value on default; it does not change the character of the money the lender advanced. The contract stays in force, the cash surrender value stays inside it, and participations continue to be credited on the same basis as before, which is not a guaranteed basis.

The exit from the arrangement is the death benefit. The loan and the interest that has accumulated on it are repaid to the lender from the death benefit when the person insured dies, and the balance passes to the named beneficiary. Nothing on that day is a disposition either, for a reason set out below. So the route that the phrase describes is a loan, taken against insurance, repaid at death, with no income inclusion at any step while every step goes as planned.

That last clause is the whole of the honesty required. The route is tax-free while it holds, and it holds only while a lender is willing to lend, the interest stays within what the contract can carry, the contract stays exempt and nobody surrenders it. How a lender sets the arrangement up, what percentage of the cash surrender value it will lend against and how the facility is documented are on the insured retirement plan page, which this page does not repeat.

What makes the collateral route fail?

Four things, each ordinary rather than remote. A lender can demand repayment or more collateral, interest compounds against a cash surrender value that must keep growing faster than the debt, the contract must stay an exempt policy, and a contract surrendered to repay the lender triggers subsection 148(1) of the Income Tax Act on the whole gain at once.

The lender comes first because the lender holds the discretion. A collateral loan is a commercial credit facility, granted on the lender's terms, and those terms commonly include the right to demand repayment, to require additional security where the balance approaches an agreed percentage of the cash surrender value, and to change the interest rate. Nothing in the contract of insurance binds the lender, and nothing in section 148 obliges a lender to wait for a death. A person who has drawn on the facility for years has no other source of repayment in most cases, which is exactly the situation in which a demand hurts most.

Interest comes second because it never stops. The loan is typically not serviced during the borrower's lifetime, so interest is added to the balance and the balance grows at the lender's rate every year. The cash surrender value that secures it grows at whatever the insurer's contractual guarantees and the credited participations produce, and participations are not guaranteed. Where the debt grows faster than the security for long enough, the lender's percentage limit is reached, and the first failure above follows from the second.

The exempt status comes third, and the surrender comes last. The tax deferral inside the contract depends on the contract remaining an exempt policy under section 306 of the Income Tax Regulations, which is a test the insurer administers and which large or unusual premiums can disturb; the detail is on the tax deferred growth page. And a contract surrendered, whether at the lender's demand or the owner's, is a disposition under subsection 148(9), so subsection 148(1) includes the entire excess of the cash surrender value over the adjusted cost basis in income in a single year, after a lifetime of deferral and in the year the person can least afford it. A route that ends that way was never free; the tax was waiting.

Is the death benefit taxed when it repays the lender?

No. The definition of disposition in subsection 148(9) of the Income Tax Act excludes a payment under a life insurance policy in consequence of the death of the person insured. No disposition means nothing for subsection 148(1) to include, so the death benefit is not income to the beneficiary, whether or not a lender is paid from it.

What the assignment changes is the order of payment. The lender holding the assignment is paid what it is owed, which is the loan and all the interest that has accumulated on it, and the beneficiary receives the balance. A policy loan outstanding with the insurer is deducted in the same way before anything is paid out. The tax character of the whole payment is the same on either side of the deduction; what changes is the amount reaching the family.

That is the honest picture of the third route from end to end. Money borrowed during life is repaid from money that would otherwise have gone to the beneficiary, and the exemption for a payment on death is what makes the repayment invisible to the return. How what arrives at death is taxed more broadly, including a corporately owned contract and the final return, is set out on the taxes on death benefits page, and this page defers to it.

What does the word tax-free honestly describe?

One route, under conditions, and never the product. The phrase is accurate for a collateral loan from a third party lender while the loan stays a loan, the contract stays exempt and nobody surrenders it. It is wrong for a withdrawal, half right for a policy loan, and wrong for the contract, which is insurance and not an investment.

Stated as a feature, the phrase misleads in two directions at once. It suggests that the growth inside the contract has been taxed and cleared, when it has only been deferred. And it suggests that the income arrives without cost, when it arrives as a debt that compounds and is settled from a death benefit that was bought with premiums over decades. A reader who hears tax-free and stops listening has not been told how the route works.

The strategy is the Canadian application of the approach known as The Infinite Banking Concept®, originated by R. Nelson Nash; the mark belongs to Infinite Banking Concepts, LLC, with which this practice has no affiliation. Within the strategy, a contract is drawn on during life by policy loan far more often than by withdrawal, and a collateral arrangement with a lender is a separate decision made late, with a Chartered Professional Accountant and with the lender's terms in writing. This practice describes that state of affairs as Infinite Financial Sovereignty®, meaning the state of holding the highest practical level of control over the capital-flow function in one's own affairs, and control includes knowing which of three routes one is on.

The honest conclusion is short. None of the three routes is free. A withdrawal pays tax now, a policy loan pays tax past a threshold, and a collateral loan pays interest to a lender and settles from the death benefit, with a tax bill held in reserve for the day the arrangement breaks. Which of those a person can carry is a question about that person's other income, other assets and tolerance for a lender's discretion, and it is answered with an accountant, not with a slogan.

Who this suits, and who it does not

It suits a person who has owned a participating contract for many years, has other retirement income, and wants to know what the phrase rests on. It suits a person choosing between a policy loan and a withdrawal. And it suits anybody shown a projection of a collateral arrangement who wants to know what it assumed.

It suits them because each of those questions has a statutory answer that an insurer's statement and an accountant's reading can settle, and because the answer arrives before any money moves rather than on a return the following spring.

It does not suit a person whose retirement depends on a single contract, because a route that relies on a lender's continued willingness to lend is not a foundation, and a forced surrender under subsection 148(1) of the Income Tax Act lands hardest on the person with nothing else. It does not suit a person who wants a figure, because no figure on this page belongs to any contract, and it does not suit a person looking for confirmation that a product is tax-free, because that is not what the statute says.

Everything here is written by a person paid by commission from an insurer when a contract is issued, which is stated on the author page and at the foot of every page. Insurance is insurance, it is not an investment, and the way its value is taxed on the way out is a characteristic of the contract rather than a reason to own one. The wider framework sits under retirement planning, and every tax question raised here belongs to a Chartered Professional Accountant.