Foreign Life Insurance Policy Disposition

Forum|Forum|3 years ago
December 27, 2022
2 replies
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Hi, I am a resident alien in U.S., born in Canada. I just (2022) cashed in two long-time Canadian life insurance policies, one a whole life policy bought by my father when I was a child (I am now 67 yo) and another a term policy I bought in the early 1980s. For most of the years, I was able to use dividends spun off from the whole life policy to pay premiums for both policies, so I have not paid premiums for years. When I cashed in the two policies, I paid federal non-resident Canada tax (about $6800 CAN) and received, net, about $19K US. Do I still pay U.S. taxes on this as Other Income or am I exempt? I am guessing Canada has a treaty with US on taxes. What IRS forms do I need to complete? Is there anyone I can consult for help on this?

TurboTax Home & Biz Windows

Anonymous_

Employee

@pk12_2

GaryinOz2002Author

Hello, did someone (tagteam?) answer my question? What is the answer? I can't seem to read it or open a message/post.

Thanks!

pk12_2

Employee

@GaryinOz2002 , can you give me a day to chew on this ? Generally, foreign life insurances are treated as non-regulated investment companies and therefore Mar-to-Market rules apply. But because Canada and US have a much closer relationship , I need to go over the treaty a bit more ( including the technical explanations).

Will circle back by 12/29

GaryinOz2002Author

Thanks, I appreciate your expertise on this issue. My thoughts are that I would enter the money I received as "Other Income" or "Income from foreign sources" and have the life insurance accounts listed under foreign assets. Since I paid foreign income tax already, I would go for a foreign tax credit, unless the taxes owed are insufficient to generate the credit. However, the alternative might be to reduce the money I received by the amount paid in foreign taxes and just list the net amount under "Other Income." I read somewhere on this board where it is possible that little of this is actually earned income and that it is just my returned investment (minus any premium I may have paid over the years, if I still have the records...). But this means I might have to list how much actual income was generated over the years, which could be difficult/impossible to know.

Just a few of my thoughts. Thanks again for your help. BTW, what are Mar-to-Market rules?

Gary

pk12_2

Employee

@GaryinOz2002 , as I mentioned earlier , most foreign life insurance schemes are treated as Passive Foreign Investment Company ( PFIC) and therefore one pays tax on the yearly gain ( a formulation based on surrender value, contribution and value at death ). There are ways around this but is quite expensive.

If I assume that you have been here in the USA for number of years and never reported / recognized this tax ( Mark-to-Market approach ) this earning, and that you are currently have or will soon liquidate/ surrender the life insurance policies and recognize the total amount for these policies, then the easiest way to handle this is ( for each policy being liquidated 😞

(a) prepare a spread sheet that shows, year by year the amount of contribution to the policy, the surrender value for the year and pay-out on death -- face value of the policy; in the contributions also include any other required expenses / fees etc. that you had to pay.

( b ) Convert all these Canadian currency contributions to US$ using the exchange rate prevalent at the time ( IRS / Treasury publishes yearly average rate for all the past years )

(c) At the end of this exercise what you should have are two figures that you need --- total contribution in US$ and the total US$ you get at surrender. The difference between the two is treated as interest earning { it is ordinary income and is the category where it fits nicely and suggested by the IRS ).

(d) please keep the print-out of the spread sheet for your records in addition to the back-up details of the transactions on the policy over the years ( to the extent feasible -- your policy admin should be able to give you this ). These are essential in case of an audit --- show that you followed a logical path and based on back-up data.

On the subject of foreign taxes paid , generally --- you use form 1116 to report the foreign income and the taxes paid thereon. However note that while IRS will recognize the total amount of taxes paid ( us$) but available for the year is limited by a ratio of foreign income to world income . The un-used portion of the credit can be carried back or carried forward-- but to avail it you still need foreign income ( because the same ratiometric limitation would be applied. A safe harbor ( from the limitation and therefore use of form 1116 ) amount of US$ 300 per taxpayer is also available ( i.e. US$600 per jointly filed return ).

An erroneous but sometimes used method is to subtract the foreign tax from the received amount ( i.e. use the net foreign income-- post foreign tax ). Depending on your total income from US sources ( assuming this liquidation is your only foreign income ), this method may not change the IRS take enough to trigger audit. If you are going to use this method ( i.e. net of foreign taxes ), please work out both ways to make sure that it is worth your while.

I did go through the US-Canada treaty and the associated protocols and while there is carve out for Canadian pension plans , there is none for Life Insurance. So ...

I hope I have answered your query sufficiently. Is there more I can do for you?