Are Life Insurance Dividends Taxable?

When Life Insurance Dividends are Usually Not Taxable

You may receive life insurance dividends only when you own a participating whole life insurance policy and the insurer performs well. Dividends are never guaranteed, meaning you may or may not get them. When you receive the dividends, you can use them in multiple ways. Dividends are typically tax-free in the cases listed below: 

• If the value of dividends you receive is less than the total premiums you’ve paid, the dividends are tax-free. In this case the cumulative dividends are generally seen as a return of premium and not considered income.
• You can also use your dividends for future premium payments, and when you do so, no taxes apply. This is because paying for premiums keeps your money in the policy and does not create any taxable income.
• You can also use the dividends to buy paid-up additions (PUAs) to increase the policy’s cash value and death benefit through the purchase of additional coverage. Here, the dividends remain tax-free as long as they do not exceed the total premiums paid so far.

Read: Can You sell Your life insurance policy

When Life Insurance Dividends May be Taxable

As an exception to the general tax-free treatment, dividends can be taxable based on how much you receive and how you use them. In short, dividends are taxable when they exceed the amount you’ve paid in premiums.

• When the amount of dividends you receive is higher than the total premium you’ve paid in the policy, the excess value you receive is treated as taxable income.

  Let’s say you paid $8,000 in premiums over multiple years and you receive $9,500 in total dividends. The excess $1,500 will be treated as taxable income for the year in which it exceeded your total premiums paid.

• When you receive the dividends, you have the option to reinvest them in the policy to accumulate interest. While the dividend is tax-free, any interest you earn on it is taxable.

• If you surrender your life insurance policy, you may receive a cash surrender value. If the amount you receive is more than the premium you’ve paid (your cost basis), the excess value is taxable. In this case, the dividends themselves are not taxable, but if they contribute to building the cash value, the excess amount contributes to the taxable gain at surrender.

Here’s an example: let’s assume the following for a whole life insurance policy with total paid-up premiums of $30,000 and cash surrender value of $40,000:

IRS Treatment of Dividend Options

If you receive dividends through your whole life policy, you have flexibility on how you wish to use them. You may take dividends as cash, use them for future premium payments, purchase PUAs, or reinvest them to accumulate interest. The IRS considers dividend usage differently for tax treatment.

• Cash Dividends: You can receive your dividends as cash through a direct payment. These payments are typically tax-free unless the total amount you receive is higher than the premiums you’ve paid. If the value of dividends is higher, the excess amount beyond the cost basis is often viewed as taxable.
• Premium Reduction: You can also use the dividends received through your policy to reduce the cost of your future premiums. When used in this way, dividend payments are not considered taxable since the fund doesn’t leave the policy.
• PUAs: Using dividends to buy paid-up additions means increasing the cash value and death benefit on the policy through the purchase of fully paid-up coverage. While dividends used here remain tax-free, the growth they add to cash value may be taxable if a future withdrawal exceeds your total premiums paid.
• Accumulate at Interest: You may also reinvest your dividends to earn interest by keeping them with the insurer to grow over time. In this case, the interest you earn is taxable, even if you don’t withdraw it.
• One-Time/Special Dividends: Similar to other dividend options, large or irregular dividends are also tax-free unless they exceed your cost basis. Any excess amount you receive is considered as taxable income. 

How Cost Basis Affects the Taxation of Your Dividends

Cost basis means the total amount of premiums you’ve paid into the policy. It’s an important factor that determines the tax penalty on your dividends. Your cost basis helps determine whether dividends are taxable. As long as cumulative dividends stay below your total premiums paid, they remain tax-free. But when the cumulative dividend value is higher than the cost basis, the excess amount is taxable.

Read: Is Life Insurance Tax Deductible

How to Avoid Taxes on Life Insurance Dividends

If offered, life insurance dividends may offer an additional financial value. But to maximize the benefits, you may want to use strategies that help reduce potential taxes. Here are actions to consider:

• You may consider using your dividends through options typically seen by the IRS as tax-free, such as using dividends for premium payments.
• You can also use dividends to purchase paid-up additions. Using dividends for PUAs may not pose any tax directly, but the growth it adds to the cash value can be taxable.
• It’s good to keep a regular check on your cost basis and track your dividends to make sure they don’t exceed the premiums paid. If in excess, you may prefer to not withdraw them but use them for future premiums.