Can You Withdraw Dividends From Life Insurance?

Life insurance policies offer features beyond a death benefit. Among these are dividends, which represent a share of an insurance company’s financial surplus. Understanding how these dividends function and the options for their use, including cash withdrawal, is important for policyholders.

Understanding Life Insurance Dividends

Life insurance dividends are distributions from an insurer to its policyholders, associated with participating whole life insurance policies. These payments are not guaranteed, reflecting the company’s financial performance and operational efficiency. Dividends are paid by mutual insurance companies, which are owned by their policyholders, or by stock companies that offer participating policies.

The generation of these dividends stems from several factors, including favorable mortality experience, lower-than-projected operating expenses, and higher-than-expected investment returns on the premiums collected. When the actual experience of the insurer is better than the assumptions used to price the policies, a surplus may be created. This surplus can then be distributed to eligible policyholders as a dividend.

Options for Using Life Insurance Dividends

Policyholders with dividend-paying life insurance policies have several options for using these distributions. One option is to receive dividends as a cash payout. When this option is selected, the insurance company issues a check or an electronic payment to the policyholder for the dividend amount. This provides immediate access to the funds.

Another option is to apply dividends to reduce future premium payments. This can decrease the out-of-pocket cost, sometimes covering the entire premium. Policyholders can also choose to leave dividends with the insurer to accumulate at interest. These funds grow over time and may be withdrawn later, providing a flexible savings component.

Dividends can be used to purchase paid-up additions (PUAs) to enhance policy value. PUAs are small, fully paid-for increments of additional life insurance that increase both the policy’s cash value and its death benefit. This creates a compounding effect, as these additions earn future dividends. Dividends can also repay outstanding policy loans, restoring the full death benefit and cash value.

Tax Implications of Dividend Withdrawals

When life insurance dividends are withdrawn as cash, their tax treatment is favorable, as they are considered a “return of premium.” The IRS views these dividends as a refund of an overpayment, not taxable income. Consequently, dividends received are not subject to income tax up to the total amount of premiums paid into the policy.

The “First-In, First-Out” (FIFO) rule applies to distributions from non-Modified Endowment Contracts (MECs). Amounts withdrawn are first treated as a non-taxable return of the policyholder’s premiums (cost basis). Only if the cumulative dividends and withdrawals exceed the total premiums paid will the excess amount be considered taxable income. For instance, if a policyholder paid $50,000 in premiums and receives $55,000 in cash dividends, the initial $50,000 would be tax-free, but the additional $5,000 would be taxable as ordinary income.

If a policy is classified as a Modified Endowment Contract (MEC), withdrawals, including dividends, are taxed differently under a Last-In, First-Out (LIFO) rule. Under LIFO, earnings are taxed first and may be subject to a 10% penalty if the policyholder is under age 59½.

Impact of Dividend Withdrawals on Your Policy

Receiving life insurance dividends as cash directly impacts the policy’s long-term growth and performance. When taken as cash, dividends are no longer available for the policy’s internal growth. This means the cash value grows more slowly than if dividends were reinvested. Cash value growth is a feature of permanent life insurance, providing a financial resource accessible during the policyholder’s lifetime.

Taking dividends as cash also limits the death benefit’s potential to increase. If dividends purchased paid-up additions, both cash value and death benefit would rise. Foregoing this option means the death benefit remains at its base amount or grows only through guaranteed features, without the additional boost. Consistently withdrawing dividends impacts long-term projections, potentially reducing financial strength and total benefits for beneficiaries or the policyholder.