How Is Life Insurance Policyholder Dividend Income Taxed?

Life insurance companies may distribute dividends to owners of participating policies when financial results support a payment. For federal income tax purposes, these distributions generally reduce the policyholder’s investment in the contract. They do not immediately create taxable income until the applicable distributions exceed that investment. The tax result can change depending on the amount distributed and how the IRS treats the dividend.

A financial advisor can help you evaluate how life insurance premiums factor into your long-term financial planning.

What Is a Life Insurance Dividend?

A life insurance dividend comes as a return of a portion of the premiums paid by the policyholder. Typically the amount derives from payments made by the policyholder in the previous year. Dividends are associated with participating policies, which may distribute a portion of the insurer’s financial surplus to policyholders. Unlike guaranteed policy benefits, the amount available for dividends can vary and does not have a guarantee.

For tax purposes, the amount you have paid into the contract is what’s most important. Dividends distributed from a life insurance contract, other than a modified endowment contract, generally represent a return of premiums. Your initial investment determines the threshold for when they exceed the net premiums paid and become taxed as income.

Are Life Insurance Dividends Taxable?

The tax treatment of a life insurance dividend depends partly on your investment in the contract. A distribution can reduce that amount first, with income tax potentially applying after the applicable basis has been exhausted. Interest credited on dividends held by the insurer is generally taxable separately. ¹

For example, assume John has paid $20,000 in net premiums into a qualifying life insurance contract. Later, he receives distributed dividends totaling $21,000. Assuming no other adjustments affect his investment in the contract, the first $20,000 would represent a recovery of those premiums. He could include the remaining $1,000 in his gross income.

Types of Life Insurance That Receive Dividends

Whether a policy can pay dividends depends on the contract rather than simply whether the coverage is permanent. Participating whole life insurance policies are a common example. A participating policy may pay dividends based on the insurer’s financial performance, while a nonparticipating whole life policy does not pay them.

Universal life and variable life policies generally use different mechanisms for crediting interest or investment performance to policy values. Do not automatically treat them as dividend-paying policies. Check the contract or ask the insurer whether a particular policy is participating and eligible for policy dividends.

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 might spend the money instead of investing it or paying down your life insurance then you may not want this option.
• Earn interest: You can keep the dividend on deposit with the insurer, where it may accrue interest. The interest credited to you generally counts as taxable income.
• Purchase additional life insurance: You can use the dividend to increase the amount of insurance provided by the policy.
• Premium deduction: You can apply the dividend against an amount due on the policy, reducing what you have to pay yourself.
• Repay a policy loan: You may be able to direct the dividend toward an outstanding loan balance associated with the policy.

How to Decide What to Do With Your Life Insurance Dividend

Start by checking your policy’s current dividend options rather than automatically taking the payment in cash. Using a dividend to reduce premiums could lower the amount you need to pay out of pocket, while purchasing paid-up additional insurance can increase the policy’s coverage and cash value. Leaving the money with the insurer may generate interest, but that interest is generally taxable.

Also review your investment in the contract before taking a large dividend distribution. The IRS generally calculates the cost of a life insurance policy using premiums paid, adjusted for items that can include previously received dividends. Keeping records of premiums and prior distributions can therefore become important when determining whether a future payment is taxable.

Your broader financial needs can help determine which option makes sense. Someone trying to reduce annual expenses may prefer applying dividends toward premiums, while a policyholder who wants additional coverage may consider paid-up insurance. A financial advisor or tax professional can help assess the financial and tax effects before you change how you’ll handle future dividends.

Bottom Line

Distributing policy dividends does not automatically make them into taxable income. Their tax treatment depends on the policyholder’s remaining investment in the contract, while interest generated by retained dividends is generally treated separately for tax purposes. How you use a dividend can also affect your policy costs, coverage and future tax calculations, making it important to review both the contract and your premium history before choosing an option.

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 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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