Are Whole Life Insurance Dividends Taxable?

Whole life insurance is a type of permanent life insurance that provides lifelong coverage and includes a savings component, known as cash value, that grows tax-deferred. Some of these policies are “participating,” which allows the policyholder to receive dividends if the insurance company’s financial performance is better than expected. Unlike stock dividends, the Internal Revenue Service (IRS) does not view policy dividends as income. Instead, they are considered a refund of a portion of the premiums you have paid.

The General Tax Rule for Policy Dividends

Generally, dividends you receive from your policy are not considered taxable income because the IRS classifies them as a return of premium. This tax-free treatment is tied to your policy’s “cost basis,” which is the total amount of premiums you have paid. As long as the cumulative dividends you receive do not exceed your cost basis, they remain tax-free.

For example, if you have paid $40,000 in premiums, you can receive up to $40,000 in total dividends without any income tax. Each dividend payment reduces your cost basis. Only when total dividends received surpass your total premium payments does the excess amount become taxable income.

Tax Implications of Dividend Utilization

How you use your policy dividends can influence their tax treatment, though most common options do not create an immediate tax liability. Your choices are outlined in your policy contract and include:

• Receiving dividends in cash. This payment is tax-free as long as the total dividends received to date do not exceed your policy’s cost basis. If the total cash dividends surpass the total premiums you’ve paid, the excess amount becomes taxable as ordinary income.
• Paying premiums. Using dividends to pay your policy’s premiums is not a taxable event. The dividend amount is simply applied to the premium due, reducing your out-of-pocket expense.
• Buying paid-up additions (PUAs). PUAs are small, fully paid-up blocks of whole life insurance that increase your policy’s death benefit and cash value. Using dividends to buy a PUA is not taxed at the time of purchase.
• Accumulating at interest. You can leave dividends with the insurer to accumulate in an interest-bearing account. While the dividend itself remains non-taxable under the cost basis rule, any interest earned is taxable income each year, whether you withdraw it or not.

Taxable Events Triggered by Policy Actions

While routine dividend use is often tax-free, certain major policy actions can create a taxable event. These actions fundamentally change the status of your policy and can result in a portion of your gains being subject to ordinary income tax.

Policy Surrender or Lapse

If you surrender your policy for its cash value, you may face a tax liability. The transaction becomes taxable if the cash value you receive exceeds your cost basis. The taxable amount is the Cash Surrender Value minus your Cost Basis, and this gain is taxed as ordinary income. A policy lapse due to non-payment of premiums is treated like a surrender, and any gain over your cost basis at the time of the lapse would be taxable.

Policy Loans

Taking a loan against your policy’s cash value is not a taxable event, as loan proceeds are not considered income. However, an exception arises if the policy lapses or is surrendered while a loan is outstanding. In this case, the outstanding loan balance is added to the cash value to determine the total proceeds for tax purposes.

If this total amount exceeds your cost basis, the gain is taxable. For example, if your basis is $50,000, your cash value is $40,000, and you have a $20,000 loan, surrendering the policy means your taxable gain would be $10,000 (($40,000 + $20,000) – $50,000).

Modified Endowment Contracts (MECs)

A policy becomes a Modified Endowment Contract (MEC) if it is funded with more premiums during its first seven years than allowed by the “7-pay test” under Internal Revenue Code Section 7702A. Once a policy is classified as an MEC, its tax treatment for lifetime distributions changes permanently.

Distributions from an MEC, including loans and dividends, are taxed on a “last-in, first-out” (LIFO) basis. This means any gain in the policy is withdrawn first and taxed as ordinary income. If you take a distribution from an MEC before age 59 ½, the taxable portion may also be subject to a 10% penalty tax.

Tax Reporting for Whole Life Policies

You may receive specific tax forms from your insurance company that report potentially taxable events to you and the IRS.

Form 1099-INT

If you leave dividends with the insurer to accumulate at interest, you will receive a Form 1099-INT. This form reports taxable interest of $10 or more credited to your account during the year, which must be included as ordinary income on your tax return.

Form 1099-R

A Form 1099-R is issued for other taxable events, such as surrendering your policy for a gain or taking a taxable distribution from a Modified Endowment Contract (MEC). The form will show the gross amount of the distribution and the taxable portion, which you must report on your tax return. Its full name is Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.