Are life insurance dividends taxable income?

Most people own some form of life insurance. If you own term insurance, basically, you are paying for a death benefit that will expire at some point, or the policy will pay the death benefit if you die before the term of coverage expires. The premium is enough to pay the cost of insurance.

Another type of life insurance is permanent life insurance. This type usually has a higher premium and part of each premium goes to pay for the death benefit, while the remainder of the funds go into a savings type account on the policy.

On a whole life insurance policy, you will likely receive annual dividends, paid on the savings portion of the account.

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Life Insurance Dividend Taxation

Most people own some form of life insurance. If you own term insurance, basically, you are paying for a death benefit that will expire at some point, or the policy will pay the death benefit if you die before the term of coverage expires.

The premium is enough to pay the cost of insurance. Another type of life insurance is permanent life insurance.

This type usually has a higher premium and part of each premium goes to pay for the death benefit, while the remainder of the funds go into a savings type account on the policy.

On a whole life insurance policy, you will likely receive annual dividends, paid on the savings portion of the account.

Whole life policies will have pre-set increases in cash values. If the insurance company does better than expected, it will pay a dividend to whole life policyholders.

These dividends are not typically taxed because they are considered as a return of premium, whether they are given as cash, used to reduce premiums, or buy paid-up insurance. There are instances where life insurance dividends are taxable though.

If life insurance dividends are left with the insurance company and they accumulate interest which exceeds the premiums that have been paid into the policy, then dividends paid above the premium paid will be taxed. This will be the case, whether or not you are still paying premiums.

So, when you get back more than you paid in, while you, the insured is still alive, you will incur taxes. U.S. armed forces veterans and their beneficiaries are the only people exempt from paying taxes on life insurance policy dividends.

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Ways to Avoid Paying Taxes on Life Insurance Premiums

If you have reached the point at which your policy dividends are exceeding the amount you paid into the contract, you may want to leave the dividends in the policy and take a loan against the cash values tax-free.

You don’t need to pay off the loan, however, when you die, the amount of the loan and any unpaid interest will be deducted from the death benefit. This allows you to get your dividends without paying income tax on them.

Businesses and Life Insurance

If business life insurance premiums are deducted from a tax return, then dividends that are paid on the policy are taxable.

You can reduce the deduction you claim as a deduction for the premium as well. Life insurance dividends usually come from a lower mortality experience, investment returns and savings on expenses.

Ways You May be Taxed on Life Insurance Dividends

As mentioned earlier, dividends that exceed what you paid into then will be taxed. However, if you surrender your policy – cash it in, you will also be taxed on the amount you receive above and beyond what you paid into the policy.

The gain on the surrender will be calculated as the difference between your basis and what you receive from the surrender.

The basis of the policy is calculated by taking the total premiums paid in, minus any dividends you received and any tax-free withdrawals you made. Any outstanding policy loans and unpaid interest would also be deducted.

If you leave your dividends with the insurance company, any interest you earn on them will also be taxed as income.

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Indexed Universal Life

An Indexed Universal Life policy can provide tax advantages that protect your life insurance dividends from taxation. With this type of life insurance policy, there are no taxes due during the buildup of the cash value.

The indexed side of the contract protects you from downside movements in the stock market. If the markets do well, you receive a percentage of the gain based upon the index your contract follows. It accumulates tax deferred while in the account.

You can access your cash value and gains on the account at any time without paying taxes or penalties, by borrowing from the policy.

This type of life insurance policy earns interest on the savings account side, which in turn earns interest.

You are also earning interest on the amount that you would have had to pay in taxes. The indexed universal life insurance policy, gives you life insurance, protects you from down markets as well as serves as a tax haven.

This is the only type of life insurance policy where you can defer taxes on the gains made in your contract.

Modified Endowment Contract

A modified endowment contract (MEC) is a life insurance contract that is deemed to have been entered into for the purposes of building tax-favored cash value and dividend accumulation.

If the cumulative premiums paid into the contract in the first seven years are enough to pay the policy up, then it is defined as an MEC. These contracts do not receive the favorable income tax treatment that other life insurance contracts receive.

Tax-favored borrowing, withdrawals of dividends or other withdrawals may be lost.

Prior to the change in laws governing the taxation of MEC’s, it was possible for a person to purchase a life insurance policy and deposit a large amount of cash into the policy immediately, letting the cash grow on a tax-deferred basis.

If the cash was needed, the policy owner could borrow from the cash value on a tax-free basis or take tax-free withdrawals. These instruments started being used as tax shelter devices.

Congress then passed federal tax acts that stopped the income tax advantages these vehicles provided. Today, withdrawals from these plans can be not only taxed, but can receive additional penalties.

Death benefits are normally tax free to beneficiaries under a MEC. Funds taken as a lifetime income from, MECs are taxed as income or gains first, then as a return of principal, until all the funds are dispersed, much like a deferred annuity. The amounts treated as income or gains first include, policy loans, interest accrued and assignments.

Since the MEC is considered to be a non-qualified retirement account, any loans or withdrawals before age 59 ½ will not only have to be declared as income in that year, there will also be potential for a 10% penalty on the gain in the amount withdrawn.

Most Dividends on Life Insurance are Not Taxable

When you have a whole life insurance policy, for the purposes of leaving a death benefit to survivors, that pays a regular dividend, most of the time the dividend is going to be considered as a return of premium, which is not taxable.

There are special circumstances where there might be an exception. If you have had a policy for a long time and you are now receiving dividends that exceed the amount you paid into the policy, then you need to report the excess dividends as income.

Another time you may have to declare dividends as income, is when you take a deduction from your taxes for the premium, as in business insurance.

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