Are Policy Dividends Considered Taxable Income?
While often considered a non-taxable refund, policy dividends can become taxable income depending on how they are used or when they exceed your total payments.
A policy dividend is a feature of a participating life insurance policy, typically issued by a mutual insurance company. These dividends are not guaranteed but represent a return of a portion of the premiums paid by the policyholder. They arise when the insurer’s financial results are better than anticipated. The tax treatment of these dividends depends on how they are received and the overall financial status of the policy.
Policy Dividends as a Return of Premium
The Internal Revenue Service (IRS) does not consider policy dividends to be taxable income because they are treated as a refund of an overpayment of premiums. If an insurer’s costs are lower than projected, it may return some of that excess premium to you as a dividend.
This tax-free treatment is linked to the policy’s “cost basis,” the cumulative amount of premiums you have paid. As long as the total dividends received do not exceed your total premium payments, the dividends are a tax-free return of your own money. Each dividend received reduces your cost basis but does not create a taxable event.
Scenarios Creating Taxable Income
The tax-free nature of policy dividends has limits. The most common scenario for taxation occurs when the total dividends received by a policyholder surpass the policy’s cost basis. Once the sum of all dividends exceeds the total premiums paid, any additional dividends are considered taxable as ordinary income at the policyholder’s regular tax rate.
For example, if a policyholder paid $50,000 in premiums and received a cumulative total of $51,000 in cash dividends, the $1,000 that exceeds the premium payments is subject to income tax.
Tax Implications of Dividend Options
Policyholders are presented with several ways to use their annual dividends, and each choice has a distinct tax consequence.
- Receiving the dividend in cash or using it to reduce the next premium payment is considered a tax-free return of premium until the total dividends exceed the policy’s cost basis.
- Using dividends to purchase “paid-up additional insurance,” or PUAs, is not a taxable event and buys a small, fully paid-up policy that increases the death benefit and cash value.
- Applying dividends to repay an outstanding policy loan is also not a taxable event and simply reduces the loan balance.
- Choosing to let dividends accumulate at interest with the insurer creates an annual tax liability on the interest earned, which is reported on Form 1099-INT.
Special Considerations for Modified Endowment Contracts
The standard tax rules for policy dividends change if a life insurance policy is classified as a Modified Endowment Contract (MEC). A policy becomes a MEC if it is funded with more money than is allowed under federal tax law, failing the “7-pay test.” This test determines if cumulative premiums paid during the first seven years of the contract exceed the total of seven level annual premiums.
Once a policy is a MEC, any distributions, including cash dividends, are taxed under a “Last-In, First-Out” (LIFO) accounting method. This means that any gains in the policy are considered to be withdrawn first, before the cost basis. This is a direct reversal of the “First-In, First-Out” (FIFO) treatment that non-MEC policies enjoy.
Distributions from a MEC are taxable as ordinary income until all the growth has been withdrawn. Furthermore, distributions of gains from a MEC before the policyholder reaches age 59 ½ are subject to a 10% penalty tax, in addition to ordinary income tax. This penalty applies to the taxable portion of any withdrawal, loan, or cash dividend.