Life insurance policy dividends are returns on premiums that a policyholder receives from the insurance company when it has surplus earnings. As a general rule, life insurance policy dividends are not taxable as these are considered as return of premium. This means that policyholders can receive dividends without worrying about an added tax burden. However, there are certain circumstances where taxes may apply, which we will explore in the following sections. Consulting a financial advisor can help provide a deeper understanding of these exceptions and their potential tax implications.
What Is a Life Insurance Dividend?
A life insurance dividend is considered a return of a portion of the premiums paid by the policyholder over the past year. They are typically paid on participating policies, which are policies eligible to receive a share of the insurer’s surplus earnings. These dividends are generated when the insurance company’s investments perform well, expenses are lower than expected or the insurer experiences fewer death claims than projected.
Essentially, life insurance dividends are a reflection of the insurance company’s financial performance. If the company does well, policyholders benefit through dividends. Visualizing this relationship would reveal that as the insurer’s performance improves, policyholders receive larger dividends.
Are Life Insurance Dividends Taxable?
It’s important to note that life insurance dividends are generally not taxable. They are perceived as a return of a portion of the premiums you pay, which come out of the insurer’s profits. Though situations where taxes apply do exist, these aren’t the norm and typically involve dividends exceeding paid premiums as highlighted earlier.
To illustrate this topic, let’s consider the case of John, a policyholder of a life insurance policy. Throughout the year, John has paid $20,000 in premiums. At the end of the year, his life insurance company declares dividends of $21,000, and John is entitled to a significant portion of it. Though most of these dividends are return of premium and are not taxed, if John’s share exceeds the total amount of premiums he paid ($20,000), the excess would normally be subject to tax.
Types of Life Insurance That Receive Dividends
Different types of life insurance policies can become eligible for dividends. The primary types include:
- Whole life insurance: This insurance policy not only provides guaranteed lifelong coverage, but it also has a cash value function that can grow over time.
- Universal life insurance: Another permanent insurance type that can earn dividends, offers flexible premiums and a potential increase in value over time.
- Variable life insurance: A type of permanent life insurance where the policyholder can invest the cash value into various investment options. This type of policy offers the potential for higher returns but also comes with more risk due to the investment component.
Choosing one of these policies depends entirely on the unique, individual circumstances of the policyholder.
Options to Receive Your Dividend
As a policyholder, you have several options on how to receive your dividends. These include receiving them as a cash payment, leaving them with the insurance company to earn interest, using them to purchase additional life insurance, repaying a policy loan or reducing future premium payments. Each of these options can impact your financial situation in different ways. Let’s take a closer look at each.
- Cash payment: This is the most straightforward way as you’ll just receive the money directly. If you’re worried you may spend the money instead of investing it or paying down your life insurance then you may not want this option.
- Earn interest: You can leave the money in a separate savings account with your life insurance company and start earning interest on the money before receiving the benefit. Any interest earned would be taxable.
- Purchase additional life insurance: You can take the money and roll it directly into buying more life insurance.
- Premium deduction: You can use the dividends to offset the cost of future premiums.
- Repay a policy loan: If you took out a loan against your life insurance payouts then you might want to catch up by using the money to pay down your loan.
Understanding life insurance policy dividends and their tax implications is crucial in managing your policy effectively. This comprehension not only equips you with the knowledge to optimize the potential tax advantages but also enhances your ability to make informed decisions. Consulting a financial advisor can help you navigate this complex landscape and benefit from a more robust financial management.
Tips for Estate Planning
- As you plan out your estate, it’s important to have an expert on your side who can help protect your assets. A financial advisor can help set up your estate plan and make sure your wishes become a reality. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Before deciding on your final estate plan, make sure you have a good grasp of the federal estate tax.
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