How Are Policyowner Dividends Treated?

Policyowner dividends are payments from an insurance company to policyholders, typically associated with participating life insurance policies. Dividends represent a portion of the insurer’s surplus earnings, which arise when the company’s financial results are better than anticipated.

Understanding Policyowner Dividends

Policyowner dividends represent a return of excess premium paid by the policyholder. These payments are not guaranteed and depend on the insurer’s actual experience regarding mortality rates, operating expenses, and investment returns. When the company performs better than its initial assumptions, a surplus is generated and distributed to eligible policyholders.

Policyowners have several options for how to use their dividends. They can choose to receive dividends directly in cash, or apply them to reduce future premium payments. Many policyholders also use dividends to purchase paid-up additional insurance, which increases the policy’s death benefit and cash value.

Dividends can also be left with the insurer to accumulate interest. Policyowners may also use dividends to repay outstanding policy loans.

Tax Treatment of Policyowner Dividends

Policyowner dividends are considered a return of premium, not taxable income, up to the policy’s cost basis. The cost basis refers to the total premiums paid into the policy. As long as cumulative dividends do not exceed total premiums paid, they are not subject to income tax.

Dividends become taxable income when the cumulative amount received or applied surpasses the total premiums paid into the policy. Any portion of the dividend that exceeds this cost basis is then taxed as ordinary income. For example, if a policyholder has paid $50,000 in premiums and receives $55,000 in dividends over time, the initial $50,000 would be non-taxable, but the excess $5,000 would be considered taxable income.

When dividends are left to accumulate with the insurer, the dividend itself remains non-taxable as a return of premium. However, any interest earned on these accumulated dividends is considered taxable income in the year it is credited, regardless of withdrawal. This interest income is subject to ordinary income tax rates.

Dividends used to purchase paid-up additions (PUAs) are not taxable at the time they are applied. The dividend serves to increase the policy’s cash value and death benefit. However, the growth in cash value from these paid-up additions becomes subject to taxation rules upon withdrawal or surrender if the amount withdrawn exceeds the policy’s cost basis.

Special tax rules apply to dividends from Modified Endowment Contracts (MECs). A life insurance policy can be classified as an MEC if it fails the “7-pay test.” Dividends from MECs are subject to “last-in, first-out” (LIFO) taxation, where withdrawals are first considered distributions of earnings. These earnings are taxed as ordinary income, and a 10% penalty tax may apply if the policyholder is under age 59½.

Reporting Policyowner Dividends

If policyowner dividends are non-taxable because they do not exceed the policy’s cost basis, the insurance company typically does not issue a Form 1099-R or any other tax form for those dividends. Consequently, the policyowner is generally not required to report these non-taxable dividends on their tax return.

A Form 1099-R is issued in specific circumstances. This form is generated if the dividends paid or applied exceed the policy’s cost basis, reporting the taxable portion of the excess. Additionally, if dividends are received from a Modified Endowment Contract (MEC), they will be reported on Form 1099-R, indicating the taxable earnings and any potential early withdrawal penalty.

For any interest earned on dividends left to accumulate with the insurer, this interest income may be reported on Form 1099-INT. It is important for policyowners to maintain accurate records of all premiums paid to determine their policy’s cost basis, which is essential for calculating the taxable portion of any future dividend distributions or policy withdrawals.