Are Life Insurance Dividends Taxable?
Understand how the IRS views life insurance dividends. While often a tax-free return of your premiums, certain gains or how you use them can create tax liability.
Life insurance dividends are a feature of certain policies, such as participating whole life insurance. These payments are not like stock dividends, which are a share of a company’s profits. Instead, the Internal Revenue Service (IRS) views them as a refund of a portion of the premiums you have paid. Dividends arise when the insurance company’s financial results are better than anticipated, allowing the company to return part of the premium to policyholders.
The General Rule for Tax-Free Dividends
Dividends received from a life insurance policy are not taxable in most situations. The IRS considers these payments a return of your premium, based on the policy’s “cost basis.” Your cost basis is the total amount of premiums you have paid into the policy.
As long as the cumulative total of all dividends you have received does not exceed your cost basis, the dividends remain tax-free. For example, if you have paid $20,000 in total premiums, the first $20,000 you receive in dividends is not considered taxable income. The tax situation only changes once the total dividends received surpass the total premiums paid.
When Life Insurance Dividends Become Taxable
A taxable event occurs when the total dividends you have received from the policy exceed your cost basis. Only the portion of the dividend greater than your total premium payments is considered taxable. This amount is taxed as ordinary income, not as capital gains. For instance, if your total premiums paid are $30,000 and you have received a total of $32,000 in dividends, the $2,000 excess is subject to income tax.
Another scenario that triggers taxation is the full surrender of the policy for its cash value. If this amount is greater than your cost basis, the gain is taxable as ordinary income. For example, if you paid $60,000 in premiums and surrender the policy for a cash value of $105,000, you have a taxable gain of $45,000. The existence of an outstanding loan against the policy does not reduce the taxable gain upon surrender.
Tax Implications of Dividend Usage Options
The tax implications of your dividends depend on how you choose to use them.
- Receiving dividends in cash: The payments are tax-free until the total amount of cash you have received exceeds the total premiums you have paid. Once that threshold is crossed, any subsequent cash dividends are taxed as ordinary income.
- Reducing premium payments: Using your dividends to pay for your policy’s premiums is not a taxable event. The IRS views this as the insurer simply charging you a lower net premium for that period.
- Accumulating at interest: If you leave your dividends with the insurance company to accumulate, the interest earned on those dividends is taxable. This interest is considered income and must be reported to the IRS each year, regardless of your policy’s cost basis.
- Buying paid-up additions (PUAs): Using dividends to purchase PUAs is not a taxable event. PUAs are small, fully paid-up blocks of life insurance that increase both the death benefit and the cash value of your policy.
Reporting Taxable Events to the IRS
When a taxable event related to your life insurance policy occurs, the insurance company is required to report it to both you and the IRS. You will receive specific tax forms detailing the amounts you need to report on your income tax return.
If you earn taxable interest on dividends left to accumulate with the insurer, you will receive Form 1099-INT. This form is issued if the interest earned is $10 or more in a tax year, and the amount in Box 1 should be included as interest income on your return.
For taxable gains, such as when you surrender a policy for more than your cost basis, the insurer will issue Form 1099-R. This form will show the gross distribution amount and the taxable portion, which you must report as ordinary income.