Life insurance dividends benefit from special tax treatment that make them largely non-taxable. This being said, there are some circumstances that can make the dividends paid on life insurance policies taxable. Today we'll walk you through both the non-taxable and taxable circumstances most commonly found for individuals receiving dividends on their life insurance policies.
Refund of Premium Special Classification
Dividends paid to a life insurance policy (or any insurance policy) represent a refund of premiums paid by the policy owner. This means the IRS views the payment of a dividend to you (as a policy owner) as the insurance company giving you back some of the premiums you paid towards your policy. Because the vast majority of people pay their life insurance premiums with after tax dollars, this refund of premiums paid is not a taxable dividend payment.
However, if the sum of all dividends paid on a specific policy exceed the sum of premiums paid to the policy, dividends will become taxable as ordinary income to the policy owner.
For example assume that you own a whole life policy and you paid a grand total of $30,000 in premiums to date. You also received a grand total of $20,000 in dividends, and you opted for the cash payment dividend option for all of these dividends. Because the sum of the dividend received is less than the sum of the premiums paid, you will not owe taxes on any of the dividends received so far.
But now, let's assume after a few more years the sum of dividends receives equals $30,000, and you have not paid any additional premiums into the policy. At this point, the insurance company refunded all the premiums you paid through the payment of dividends and you will owe taxes on any dividends received as cash from here on out.
Please note that this happens only as a result of your taking the dividend as a cash payment. Taking the dividend as a cash payment reduces your cost basis in the policy. There are other dividend options that will not create the same effect on your policy.
Using Dividends for More Whole Life Benefits
If you use the dividend options to purchase paid-up additions, reduce/pay future premiums, or to purchase additional term life insurance, the net taxable result is a wash. There is no reduction of your cost basis, nor is there an increase in your cost basis.
For example, when you use the dividend option to purchase paid-up additions. You receive a refund of previous premiums you paid, but then add that refund back to your policy through the purchase of paid-up additions. This is not a taxable event. This also doesn't add to or take away from your non-taxable cost basis in the policy.
Withdrawing Dividends from a Whole Life Policy
When you withdraw dividends that purchased paid-up additions from a whole life policy, the withdrawal will first deduct from your cost basis. Assuming you have a cost basis larger than the withdrawal (very common) the withdrawal is non-taxable.
If you withdraw more from the whole life policy than you paid in premiums to the whole life policy, you will owe ordinary income taxes on the withdrawal.
For example, assume you have a whole life policy with $100,000 in cash value and you paid a total of $50,000 in premiums. You wish to take a $20,000 withdrawal from the policy. You will owe no taxes on this withdrawal because you will deduct $20,000 from the $50,000 cost basis (i.e. the premiums you paid towards the policy), which comes to you tax free (you already paid taxes on these dollars).
If, instead, you chose to take a $60,000 withdrawal from this policy, you would owe taxes on $10,000. This happens because the withdrawal removes your entire cost basis of $50,000 and the remaining $10,000 is taxable as a gain in the policy.
Is Cash Surrender Value Created by Dividends Taxable?
Any cash value in a whole life policy that you either withdrawal or receive through a full policy surrender will be taxable. U.S. Tax Code treats all cash values the same regardless of their source (i.e. dividends, elective paid-up additions, and/or guaranteed cash value accumulation). In all cases you will owe no taxes on the portion representing your cost basis. Put another way, you will always be able to deduct your cost basis from any partial or full withdrawal of cash value first before owing any taxes.
Additionally, it's important to understand that a taxable event only takes place if you make a withdrawal or full policy surrender. Cash inside a whole life policy is not taxable when it remains in an active/in force whole life policy.
What Happens if you Use Dividends to Pay Premiums on Another Policy?
If you use dividends from one life insurance policy to pay dividends on another life insurance policy, you will deduct cost basis from the policy earning the dividends. This could eventually make your dividend payment taxable as ordinary income.
The dividends used will count as cost basis for the other life insurance policy, and any withdrawal or dividend received as cash carries not tax liability unless you remove its full cost basis.
For example, assume that you have a whole life policy (policy A) that you decide to being taking a cash dividend from to pay premiums due on another whole life policy (policy B). Doing this will begin to remove your cost basis in policy A, which could eventually make the dividends earned on policy A taxable as ordinary income to you. It could also make a withdrawal from policy A taxable if the withdrawal goes beyond your cost basis.
All dividends used to pay premiums due on policy B will add to policy B's cost basis. Withdrawing cash or taking the dividend payable on policy B is not taxable unless you remove all of the cost basis in policy B.
You cannot claim a refund of premium credit on one policy for another. So you cannot claim a dividend payment on policy A as non taxable because the dividend is paying premiums on policy B.
Are Term Life Dividends Taxable
While it is possible for a life insurer to pay dividend in excess of the premiums paid on a term life policy, this has never occurred to our knowledge. Practically speaking dividends paid on term life policies are always refunding a portion of premiums paid and will remain non-taxable for the entire term period.
Because term life policies have no cash value, there is no concern over what dividend payments do to the taxability of a withdrawal since none are available. Also, the cost basis of a policy does not affect the taxability of a death benefit, which remains income tax free in the majority of circumstances.
This article was extremely helpful and explained the complicated issues in a way I could understand. Thank you
I have a whole life policy that is fully paid & my cost basis is -0-. I earn dividends & DO NOT take the cash but keep the cash in the policy. These dividends earn interest. This is the 1st year I received a 1099-R for the dividend as taxable. I know this could be true if dividends exceed the total premiums I have paid in.
But – is this still taxable even though I let the dividends accumulate in the policy?
Note – the dividends are NOT used to buy more insurance in which case I believe the dividends are not taxable.
Hi Ed, this sounds like you’ve been using the dividend option to “Accumulate at Interest.” This option deposits the dividend payment into an interest-paying account. The insurance company declares the interest rate on this account once per year. If you’ve been using this option for some time, it’s possible that the dividend payments were reducing your cost basis and you just recently reached a point where this dropped your cost basis to zero. This would explain why no 1099-R arrived before now.
But you should have also received a 1099-INT for the past several years for the interest earned on the account housing the cash created when dividends went there.
When life insurance dividends are left to “Accumulate at Interest,” the interest earned on that account balance is no different from the interest on any other savings. Whereas, the dividend is a tax-free refund of basis, the interest earned on the accumulated balance is taxable like any other interest.
Think of it another way. The annual dividend could have been received in cash and deposited into a saving account, which is exactly the same situation tax-wise. In that scenario you would expect the bank to send you a 1099 on the interest earned. Same thing.
It matters not, in this case, whether the sum of dividends received exceed your premiums paid. That is irrelevant in this case.
Are there circumstances when using all of the dividend for Paid-up Additions would still result in having taxable income?
No.
The following is the response I received from MetLife on this issue:
“We are writing in response to your letter concerning the dividends and the taxable gain reported in 2021 when the policy was cash surrendered.
As previously advised the dividend option was Additional Insurance. However, the policy used Premium Offset/ Accelerated Premium to pay the premium using accumulated additional insurance. We must take into account these dividends when calculating the cost basis on the policy.
We are unable to change the 1099 tax form for 2021, per IRS rules.”
Based on the information provided above, is this response incorrect? If so, is there an IRS rule regarding this issue that I can site to amend my tax return even though I do not have a corrected 1099?
There isn’t enough information here to given an answer on correct or incorrect, but there is no reason to believe MetLife is wrong based on this response.
Here is an explanation of the issue:
My partner bought a MetLife $200,000 whole life policy in 1990 – paid up at the age of 95. She surrendered this policy in March 2021. MetLife issued a 1099-R for 2021 resulting in a very large taxable amount. What happened is that over the years my partner bought additional paid-up insurance with the dividends issued on the base policy. Then starting in 2003, she started using the paid-up additions to pay the premiums on the base policy until all the paid-up additions were surrendered. We are not disputing this fact. But MetLife is saying that the entire value of the paid-up additions is considered a withdrawal from the policy.
My research shows that using dividends to purchase paid-up insurance is not a taxable event because the dividend distribution and simultaneous premium payment or purchase of paid-up insurance for the same amount will cancel each other out. My contention is that when those dividends are subsequently surrendered as part of the paid-up additions to pay premiums, they should also not be considered taxable. They should be added to the basis which would result in a much lower taxable amount.
Hi William,
What you’ve outlined here tracks in the sense that paid-up additions surrendered to pay premiums would have a net zero impact on policy gain/cost basis. There isn’t enough detail here to address what MetLife might be seeing as gain reportable through 1099-R.
This being said, the reportable amount could be caused by the policy’s guaranteed cash value. Since using PUA’s to pay premiums is a net zero impact on cost basis, if a positive gain was achieved prior to doing this, it’s conceivable that one could remove all paid-up additions cash value through surrender to pay premiums (commonly called an “offset”) and then surrender the policy for guaranteed cash value which could in some circumstances result in a distributed gain upon surrender.
The quickest way to potentially sort this out is to compare the sum of premiums that were paid (not through PUA surrender but through the policyholder making a payment to the policy) against the cash value received upon surrender. Ignore all premiums covered by PUA’s as those are cancelled out. If cash received upon surrender is higher than premiums that were paid by the policyholder, that would be a reportable gain as ordinary income. Also, depending on the policy and certain riders, you may need to deduct the rider expenses from the premiums paid (this would not include any PUA rider) as they do not count towards cost basis in all situations.
Thank you very much for your detailed explanation. I will work on this.
$200,000 Policy was purchased in 1990.
There were no rider expenses.
Policy was surrendered in 2021 for $114,334.46. This is the guaranteed cash value at the time the policy was surrendered.
The annual premium payment was $3,936.
Total premiums paid were $125,952 ($3,936 for 32 years).
Premiums were paid in full out of pocket for the first 13 years for a total of $51,168. Premiums were also paid out of pocket in Year 30 for 1,870, in Year 31 for $1770, and in Year 32 for $3936 for a total of $58,744. (Cash received upon surrender was less than the total premiums paid out of pocket.)
Under the Accelerated Payment arrangement, amounts of $3,936 were withdrawn each year to pay premiums for years 14 to 29 for the total of $62,976. (The Accelerated Payment arrangement uses the cash value of additional policies purchased using dividends to pay premiums.)
A dividend withdrawal of $2,066 was done to pay the remainder of the premium for year 30. A dividend withdrawal of $2,166 was done to pay the remainder of the premium for year 31.
Adding all of these premium payments together ($58,744 + $62,976 + $2,066 + $2,166) results in a total of $125,952,
Dividends were used to buy additional insurance from years 1 to 29. Additional life insurance purchased in years 1 to 13 years totaled $78.856.99. (These numbers are projected because annual policy statements are not available for many years. However, the numbers tie into numbers that are available from later policy statements.)
Dividend payments for the first 13 years are projected to be $23,090. Dividend payments for the next 18 years are projected to be $33,316 for a total of $56,406.
Therefore, from years 14 to 29 of the policy, dividends were being used to purchase additional insurance while simultaneously additional insurance was being cashed in to pay premiums. So, the cash value of the additional insurance was simultaneously increasing because additional insurance was being purchased each year using dividends and decreasing because the cash value was being used to pay premiums. In addition, the cash value of the additional insurance was earning a guaranteed 5.5 per cent in interest each year.
The net effect on the cash value of the additional insurance was that the cash value was depleted at the end of year 29.
The MetLife 1099-R shows in Box 6 premiums paid out of pocket to be $60,312 vs my calculation of $58,744. Subtracting the $60,312 from the surrender amount of $114,334.46 in Box 1 yields a taxable amount of $53,422.46 in Box 2a.
MetLife’s decision is that upon surrender only the premiums paid out of pocket are not included in the taxable amount. All dividends used to purchase additional insurance plus the dividends used to pay premiums in years 30 and 31 are taxable as well as any increase in the cash value of the additional insurance because of interest payments. I believe this is incorrect.
All dividends are considered a return of premium at the time they are issued and therefore should not be taxed. In addition, dividends used to purchase paid-up additional insurance or to pay premiums on the same policy should not be taxable. This is because the dividend distribution and simultaneous premium payment or purchase of additional insurance for the same amount will cancel each other out.
What needs to be determined is how the dividends used to purchase additional insurance should affect the taxable amount when surrendering the policy, considering that the cash value of the paid-up additional insurance is also earning interest.
Hi William,
If I’m following everything correctly, she bought a whole life policy and paid the premium due for 13 years at $3,936 ($51,168 in total premiums). She then used paid-up additions to pay the premium due for 16 years. During these 16 years, the cost basis in the policy would neither increase nor decrease while using paid-up additions to pay the policy premiums due. Then for two years she used the dividend to reduce the premium and paid the remainder out of pocket adding $3,640 to her cost basis on the policy. You cannot add the premiums paid through a paid-up additions surrender to the cost basis. This would make the cost basis less than what MetLife reported in 1099. There are perhaps misquoted numbers that explain the difference here–or it’s possible MetLife made an error in her favor. But in general, their calculation regarding cost basis on the taxable income received through surrender is correct.
She accumulated $114,334.46 while physically paying around $55,000 into the policy.
I was hoping that the dividends that were surrendered when paid-up additions were used to pay premiums would have been added to the cost basis, thus lowering the taxable income. But I understand now that that is not the case. I really appreciate your advice in this matter.
You are welcome.