Policy Loans vs Withdrawals: Tax Differences in Canada
Introduction
A policy owner who needs capital from a permanent life insurance policy generally has two routes available from the insurer itself.
The first is a policy loan, an advance from the insurer against the policy. The second is a partial withdrawal, also called a partial surrender, which permanently removes a portion of the cash value.
Most owners assume the difference is simply that one has to be repaid and the other does not. That is true as a matter of contract, but it understates the tax difference considerably.
Taking the same dollar amount by the two routes can produce materially different taxable income, and in most cases the policy loan produces less. The reason sits in a single parenthetical exclusion in the Act.
Both Are Dispositions
The starting point is that neither route avoids the disposition rules.
Subsection 148(9) defines disposition to include a surrender of an interest in the policy and a policy loan made after March 31, 1978.
A partial withdrawal is a disposition of part of the interest. A policy loan is a disposition in its own right. Subsection 148(1) applies to both, requiring an income inclusion where proceeds exceed the adjusted cost basis.
So the question is not whether tax arises. It is how much.
Where the Routes Diverge
Subsection 148(4) is the prorating rule. It applies where a taxpayer disposes of part of an interest in a life insurance policy, and it requires the adjusted cost basis to be apportioned using a formula.
The apportioned amount is the adjusted cost basis multiplied by the proceeds of the disposition over the cash surrender value immediately before the disposition, reduced by outstanding policy loans for policies issued after 2016. For earlier policies the denominator is the accumulating fund.
The opening words of that subsection contain an exclusion. It applies to a disposition of part of an interest other than one described in paragraph (b) of the definition of disposition in subsection 148(9).
Paragraph (b) of that definition is a policy loan made after March 31, 1978.
The consequence is direct. A partial withdrawal is subject to adjusted cost basis proration. A policy loan is not.
On a policy loan, the full adjusted cost basis is applied against the proceeds. On a partial withdrawal, only a proportionate slice of it is.
An Illustration
Consider a policy issued after 2016 with a cash surrender value of $100,000, an adjusted cost basis of $40,000, and no outstanding policy loans. The owner needs $50,000.
Taking it as a policy loan, the proceeds are the lesser of the loan amount of $50,000 and the excess of cash surrender value over outstanding loans of $100,000. The proceeds are $50,000.
The full adjusted cost basis of $40,000 is applied. The income inclusion is $10,000.
Taking the same $50,000 as a partial withdrawal, the proceeds are $50,000, but subsection 148(4) prorates the basis. The applicable portion is $40,000 multiplied by $50,000 over $100,000, which is $20,000.
The income inclusion is $30,000.
Same amount of capital accessed, three times the taxable income.
The Second Difference: Repayment
The comparison widens further once repayment is considered.
Where a policy loan that produced an income inclusion is repaid, paragraph 60(s) permits a deduction in the year of repayment, to the extent of the amount previously included in income.
The repayment also restores adjusted cost basis under the relevant element of the subsection 148(9) formula, subject to a limiting calculation.
A partial withdrawal has no equivalent. The amount is gone. There is no mechanism to put it back and recover the tax, and the basis consumed by the proration is not restored.
The CRA has confirmed that the paragraph 60(s) deduction cannot be carried forward. Where it exceeds income in the year of repayment, the excess is lost, so timing the repayment to a year with sufficient income matters.
Where the Policy Loan Is Worse
The comparison does not run one way in every respect.
A policy loan accrues interest at a rate set under the contract. A withdrawal does not.
Where that interest is not deductible under paragraph 20(1)(c) or (d), it is treated as a premium under subsection 148(9) and increases adjusted cost basis. Where it is deductible, the owner takes the deduction instead, supported by Form T2210.
A policy loan remains outstanding against the policy. Where the loan together with accrued interest exceeds the cash surrender value, the policy terminates unless a portion is repaid. A policy that lapses in these circumstances triggers a disposition at the worst possible moment.
A withdrawal carries no such risk, because nothing remains outstanding.
Universal life policies may also apply surrender charges to withdrawals in the early years, which reduces the net amount received without reducing the proceeds for tax purposes in the owner’s favour.
The Premium Application Exception
One further feature of the policy loan rules is useful and widely overlooked.
The proceeds of a policy loan exclude any part of the loan applied immediately after the loan to pay a premium under the policy, as provided for under the terms and conditions of the contract.
Where a loan is taken and immediately applied to fund a premium on the same policy, that portion produces no proceeds and no taxable amount.
This is how policies are kept in force through periods when the owner cannot fund premiums from other sources, without generating a tax bill in the process.
Interaction Between the Two
The routes are not entirely independent.
Subsection 148(4.01) deems a repayment of a policy loan to have been made in certain circumstances where a partial disposition occurs and the amount payable under the policy loan is reduced as a consequence.
This matters where an owner with an outstanding policy loan then takes a partial withdrawal. The sequence and the mechanics need to be confirmed with the insurer rather than assumed.
Common Planning Mistakes
Several errors recur.
Taking a partial withdrawal because it seems simpler, without comparing the taxable amount against a policy loan of the same size.
Assuming a policy loan is tax free because it is called a loan.
Allowing policy loan interest to capitalize without monitoring the loan balance against the cash surrender value.
Repaying a policy loan in a year with insufficient income to absorb the paragraph 60(s) deduction.
Requesting either transaction without first obtaining the current adjusted cost basis from the insurer, which has usually declined since it was last checked.
Conclusion
Policy loans and partial withdrawals are both dispositions under subsection 148(9) and both can produce fully taxable policy gains.
The difference most owners miss is that subsection 148(4) prorates adjusted cost basis on a partial withdrawal but expressly excludes policy loans from that treatment. A policy loan applies the full adjusted cost basis against the proceeds, which generally produces a smaller inclusion for the same amount of capital.
A policy loan also carries a repayment mechanism. Paragraph 60(s) permits a deduction in the year of repayment to the extent of the amount previously included in income, and the repayment restores adjusted cost basis. A withdrawal offers neither.
Against that, a policy loan accrues interest, remains outstanding against the policy, and can cause the policy to terminate if the balance exceeds the cash surrender value.
The adjusted cost basis should be obtained from the insurer and both routes modelled before either is requested.
Tax Partners can assist you in structuring your affairs properly and ensuring full compliance while optimizing your tax position.
This article is written for educational purposes.
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