Insurance dividends are a “return of premium,” which will be partially given to the policyholder for the premium paid on the insurance policy. An insurance dividend is considered to be an annual fee an insurance company pays to its whole life policy-holders. The insurance dividend can be given in cash also, but often it is applied as a discount against future premium payments.
Normally, insurance dividends are tax-free since they are not reported on the tax returns. Life insurance dividends are a return of premiums that are paid previously for the life insurance policy. They cannot be included in the gross income until they exceed the total of all net premiums paid. If the premium is more than adequate, the owner of a participating policy is eligible to receive an equitable portion of the company’s earnings. Dividends on the common stock of a life insurance company and interest on the corporate bonds of a life insurance company are taxable.
If life insurance premiums in business are deducted from the tax return of a person and later s/he receives life insurance dividends, then the current tax year’s life insurance premium tax deduction on the tax return by the amount of life insurance dividends should be reduced, or the person should claim them to be taxable income on his/her tax return. Insurance dividends come from mortality savings, investment results, and savings on expenses.
Life insurance policies take two forms: whole and term. In a term policy, coverage is provided at a fixed rate of payment over a limited term (e.g. 30 years). Coverage ends after that period expires, or when the insured dies and the death benefit is paid to the beneficiary. By contrast, a whole life policy is an insurance policy that remains in effect for the insured’s whole life and requires premiums to be paid annually into the policy. If you have opted for a whole life policy, it is possible you will receive annual dividends. Whole life policies have guaranteed, pre-set annual cash value increases. The increases are based on a “worst-case” financial results scenario projected by the insurance company. At the end of the year, if the company did better than its worst-case projection, it pays out dividends to policyholders. In general, whole life insurance dividends are not taxed because they are viewed as a rebate – whether paid in cash, used to reduce premiums, or to buy additional paid-up coverage. There a few instances where life insurance dividends to become taxable, however, directly affecting your bottom line come tax season.
Generally, life insurance dividends are only taxable if they remain with the insurer and accumulate interest exceeding the total of premiums paid. This is true whether you are paying premiums or after the policy is paid-up. Several exceptions to this rule exist, such as when distributions come from single-premium policies, and when the policy’s cash value exceeds your investment in it (policy becomes fully paid at a rate faster than seven annual premium payments). The tax man can be fairly heavy-handed in taxing life insurance dividends, possibly even subject you to a 10% penalty tax if distributions are taken early – before age 59½. A number of complex issues will determine your tax rate on life insurance dividends, if any, so be sure to discuss your situation with your tax professional at your next meeting. A few changes to your existing policy could save you some serious cash.