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 circ*mstances 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 circ*mstances 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.
Bottom Line
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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FAQs
Life insurance dividends are generally not taxable. This is because, in most cases, the IRS considers a life insurance dividend to be a return of premiums paid.
How are life insurance policy dividends taxed? ›
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.
Which type of life insurance company pays taxable dividends to its stockholders? ›
Stock insurers are incorporated insurers whose capital is divided into shares. Stock insurance companies are owned by the stockholders who are responsible for electing the firm's board of directors. Dividends are paid to stockholders and are considered taxable income.
How are policyowner dividends treated in regards to income tax? ›
How are Policyowner Dividends Treated in Regards to Income Tax? Whole Life Insurance policy Dividends are typically treated as Federally Income Tax Free. Generally speaking, the Internal Revenue Service considers dividends a "return of your yearly annual premium" and therefore not taxable.
Are dividends paid from a life insurance policy taxable quizlet? ›
Participating policy dividends are not generally taxable. However, the interest earned on the dividend is taxable.
Do you get a 1099 for life insurance dividends? ›
You won't receive a 1099 for life insurance proceeds because the IRS doesn't typically consider the death benefit to count as income.
Are cash dividends on life insurance policies considered taxable as income by the IRS? ›
Life insurance dividends are generally not taxable. This is because, in most cases, the IRS considers a life insurance dividend to be a return of premiums paid.
How do dividends work with whole life insurance? ›
With dividend-paying whole life, insurers may pay dividends based on the policy's amount of insurance in force. Dividends are an optional payment from the insurer. The more coverage your whole life insurance policy has in force, the more you could potentially receive in dividends.
What are dividends paid on life insurance policies? ›
An annual dividend is a yearly payment granted to an insurance policyholder, often of a permanent life insurance or long-term disability policy. The dividend amount depends on factors such as profits made by the insurance company, investment performance, and the amount of money paid into the policy.
What are the policyholder dividends? ›
Policyholder dividends are a return of premium, under the terms of the policy (usually a workers compensation policy), resulting from income in excess of losses and expenses.
Whole life insurance can avoid taxes by building cash value. Your cash value savings grow tax-deferred, so you don't owe income tax as long as you leave the money in your account. In comparison, if you saved through a savings account or a bank Certificate of Deposit, you'd owe tax on your interest each year.
How do life insurance dividends affect cost basis? ›
For income tax purposes, dividends are treated as a return of unused premium and aren't taxed. If they are received in cash, they reduce the owner's cost basis. The reduction in cost basis will affect you from an income tax perspective if you decide to cash in your policy or if your policy lapses or matures.
How do I avoid taxes on cash value of life insurance? ›
The easiest way to avoid paying taxes on the cash value component of a life insurance policy is to only take out as much as you've put into the policy through premiums. Most people will only pay taxes on cash value when they distribute over their cost basis.
Which of the following distributions in a life insurance policy is taxable? ›
Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren't includable in gross income and you don't have to report them. However, any interest you receive is taxable and you should report it as interest received.
What life insurance policies are taxable? ›
Life insurance proceeds paid in a lump sum are generally received by the beneficiary tax-free. This includes term, whole, and universal life insurance. However, if the payout is set up to be paid in multiple payments the payments can be taxable.
What is a life insurance policy that does not pay dividends? ›
Non-Participating Whole Life: A non-participating whole life policy will give you a level premium and face amount during your entire life. The advantages of such a policy are its fixed costs and generally low out-of-pocket premium payments. The disadvantage is that it pays no dividends.
What happens when you withdraw dividends from life insurance? ›
You can withdraw these dividends at any time without affecting your policy's guaranteed cash value or guaranteed death benefit. However, accumulated dividends may not be redeposited once they have been withdrawn.
Are life insurance death proceeds taxed as ordinary income? ›
In general, the payout from a term, whole, or universal life insurance policy isn't considered part of the beneficiary's gross income. This means it isn't subject to income or estate taxes.
Why did I get a 1099-R from my life insurance policy? ›
What is a 1099-R? A 1099-R is simply a form that is sent out because of a potentially taxable event. Insurance companies are required to send these forms out whenever something happens to trigger it, like a full surrender of a life insurance policy, a partial withdrawal, a loan, or a dividend transaction.
