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You may have noticed a reference to “dividends”
on your life insurance policy statement and wondered whether
you had to pay tax on them. The answer depends upon the type
of policy you have, when you took the policy out, and how
much you have received cumulatively from the policy.
Generally speaking, life insurance dividends are treated
as a non-taxable return of part of your premium. As is true
with a rebate on any other kind of product, no tax is owed
on the payment. That’s the rule 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. In the latter case, you would owe
tax on the interest earned on the dividends. Dividends are
taxable if the amount of dividends, 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 premiums and after the policy is fully paid-up.
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These very favorable rules 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, and that were taken out after June
20, 1988. Dividends and other distributions from these policies
(which are known as modified endowment contracts) are treated
as coming first from the policy’s income, rather than
reducing premium payments. Thus, they are taxable to the extent
that the policy’s cash value exceeds your investment
in the policy. 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.
While these rules seem pretty straightforward, there are
a number of more complex issues. For example, policies that
aren’t modified endowment contracts when issued may become
subject to the tougher rules if benefits are reduced during
the policies’ early years.
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