Taxation of Life Insurance Policy Dividends

By | January 26, 2014

How are dividends on a life insurance policy taxed?

The following is applicable to owners of whole-life insurance policies that may pay dividends entitled to special tax treatment under IRS rules. In general, life insurance dividends are treated as a non-taxable return of part of the premium customers are paying. There is no tax because it is a return of capital and not profit on an investment. This is a broad rule that applies whether the dividends are paid to you in cash, used to reduce your premiums or to buy additional paid-up coverage, or remain with the insurer to accumulate interest.Life insurance is a unique product that provides needed liquidity during the lifetime and at the death of the insured.


Tax is owed on the interest earned on the dividends

If they remain with the insurer  and are added to the life insurance policy to accumulate interest,  tax is owed on the interest earned on the dividends because the interest itself is not tax free. Another rule is that the dividends are taxable if the amount of dividends paid from the life insurance policy together with any other amounts received tax-free from the policy exceed the total of premiums paid. These rules apply both while you’re paying life insurance premiums and after the policy is fully paid-up.

Taxation of Life Insurance Policy Dividends

Overall, these are very favorable rules that don’t apply to distributions from single-premium policies or other life insurance policies that become fully paid-up at a rate faster than seven level annual premium payments.


Taxable Distributions From Life Insurance

Life insurance proceeds paid to you because of the death of the insured person are not taxable unless the policy was turned over to you for a price. This is true even if the proceeds were paid under an accident or health insurance policy or an endowment contract. With certain exceptions, taxable distributions from these policies also are subject to a 10% penalty tax if paid before age 59-1/2. However, even dividends from modified endowment contracts aren’t taxable if used to buy additional paid-up insurance protection.


Rules concerning the taxation of life insurance dividends

The rules concerning the taxation of life insurance dividends are very complex and a taxpayer is best advised to consult an accountant to find out if there is any tax liability owed. Failure to treat the dividends on a life insurance policy could lead to severe tax penalties down the road upon an IRS audit. This could often occur a time in a taxpayers life when they are not able to face such an audit.