Taxation of Dividends in Participating Policies

A participating life insurance policy allows the policyholder to share in the insurer’s financial success through dividends. These dividends are not guaranteed but are paid when the company has a surplus from better-than-expected operations. Unlike stock dividends, the Internal Revenue Service (IRS) does not view policy dividends as investment income but as a return of a portion of the premiums you have paid.

The General Tax Rule for Policy Dividends

The primary tax principle for life insurance dividends is that they are not considered taxable income. The IRS treats a policy dividend as a refund of an overpayment of premium, meaning you are getting back money you already paid to the insurer. This treatment is tied to the policy’s cost basis, which tracks your investment in the contract.

Your cost basis is the cumulative total of all premiums you have paid. When you receive a dividend, it is a non-taxable event that reduces this cost basis. For example, if you have paid $20,000 in total premiums, your basis is $20,000. A $500 dividend reduces your basis to $19,500, and you do not report the $500 as income for that year.

Tax Implications of Dividend Options

Receive in Cash / Reduce Premiums

When you elect to receive policy dividends in cash or use them to pay your premiums, the distributions are not immediately taxable. They are treated as a return of your premium payments and directly reduce your policy’s cost basis. For instance, if your annual premium is $2,000 and you receive a $300 dividend, applying it to the premium means you only pay $1,700 out-of-pocket, and your cost basis for that year increases by $1,700.

Purchase Paid-Up Additions (PUAs)

Choosing to use dividends to purchase paid-up additions (PUAs) is also not a taxable event at the time of purchase. This option allows you to buy small, fully paid-up blocks of life insurance that increase both your death benefit and your cash value. Since the value remains inside the policy, no income is considered to have been received by the policyholder, and therefore no tax is due.

Accumulate at Interest

An exception to the rule arises when you leave your dividends with the insurance company to accumulate at interest. While the dividend itself remains a non-taxable return of premium, any interest earned on those accumulated funds is considered taxable income. This interest must be reported annually in the year it is credited, and the insurance company will issue a Form 1099-INT detailing the amount to report.

When Policy Dividends Become Taxable

The non-taxable nature of policy dividends changes when total distributions from the policy exceed your investment in the contract. The IRS views any funds received beyond your total premium payments as a gain, which is subject to taxation as ordinary income.

This can be triggered by lifetime withdrawals. If the cumulative amount of dividends you have received in cash, plus any other policy withdrawals, surpasses the total premiums you have paid, the excess amount is taxable. For example, if you have paid $50,000 in premiums and over the years have received $55,000 in cash dividends and withdrawals, the $5,000 difference is taxable income.

Another taxable event is the full surrender or maturity of the policy. When you surrender the policy for its cash value, you must calculate the taxable gain. The formula is the total cash surrender value you receive minus your policy’s cost basis (total premiums paid less any dividends already distributed).

Tax Treatment at Death

The tax treatment of a participating life insurance policy upon the death of the insured is favorable for the beneficiaries. The death benefit, which consists of the policy’s original face amount plus the value of any paid-up additions and accumulated dividends, is received free from federal income tax. This means the entire sum is not considered part of their gross income.

This income-tax-free status applies regardless of the amount of gain that may have existed within the policy. If the cash value had grown to exceed the premiums paid, that gain is extinguished at death and is not taxed to the beneficiaries. The proceeds are passed on without being diminished by income taxes.

A rare exception is the “transfer-for-value” rule. If the policy was transferred to another party for valuable consideration, a portion of the death benefit could become subject to income tax. This situation is uncommon for most policyholders but can occur in specific business or estate planning contexts.