Are Life Insurance Dividends Taxable?

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.


6 thoughts on “Are Life Insurance Dividends Taxable?”

  1. 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.

  2. 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.

  3. Are there circumstances when using all of the dividend for Paid-up Additions would still result in having taxable income?


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