How are Policyowner Dividends Treated in Regards to Income Tax?

Whole Life Insurance policy Dividends are typically treated as Federally Income Tax Free. Generally speaking, the Internal Revenue Service considers dividends a "return of your yearly annual premium" and therefore not taxable. However several caveats exist and federal income tax is not the only type of tax potentially involved. There is no blanket answer to this fundamental question. According to the New York Department of Financial Services: "Dividends generally are considered to be a "return of premium" and are not taxable as long as the dividends you have received do not exceed the premiums you have paid."

Although many consumers are aware that the death benefit of a typical life insurance policy are often tax free to the beneficiary, the tax status of the dividends is less well  known.

There are of course numerous other types of taxes that may pertain to death benefit payout, those we will review later on.  These include State Income, Federal and State Inheritance and taxes.

The same goes for policyowner dividends. Just because you do not have to pay federal income tax does not necessarily mean that some other sort of tax will not apply.

Some Notes and Qualifications:  First off, at WholeVsTerm we are insurance agents and not legal experts or tax experts. We write and blog about this matter based on our insurance understanding and we cite legitimate resources.  Second this refers to life insurance as it pertains to the United States of America. Third, this subject can and will change.  With tax law, things can change quickly.  Fourth and last everyone's circumstances are unique.  In other words see your own licensed tax specialist.

If you prowl around the internet, you may come away with the conclusion that whole life insurance is tax free.  This is not true.  The internet is a great source for information, sadly it is often oversimplified.  Yes generally the death benefit from a life insurance policy CAN be income tax free.  And the dividend from a participating insurer CAN be income tax free.  Regardless of it is a direct recognition policy or not.  But those two statements does not mean that 1. There  is no tax involved and 2. That you will not be charged income tax necessarily.  In this article we discuss those two discrepancies: The Other Taxes and Some Reasons that you May pay income tax on an insurers dividend.

Here is the rundown on the numerous types of taxes that may apply when you buy, hold insurance:

Premium Tax:  This hidden tax is levied by a handful of states when you purchase or pay your annual premium for life and potentially other types of insurance.  Typically this is not something that the consumer may even be aware of. 

State Retaliatory Insurance Tax:  These are taxes that one state may levy on another state's insurers. This too is often something that consumers may be unaware of.

Federal Income Tax:  Everyone knows that the federal government of the United States charges income on what you earn.  Also under this category are so called Dividend (Corporation not Life Insurance) and / or unearned income tax. These are various taxes charged on investments.  In general the federal government does not charge an income tax on a dividend policy received and held from a life insurer.  The death benefit payment as well is often income tax free.  There are caveats and requirement for this to be the case.

State Income Tax:  States also collect income tax and many use very similar forms and general rules as the government.  There does not seem to be any information publicly available about any state that either taxes the death benefit amount or a dividend reception.

Federal Estate Tax:  The federal government may tax your estate if your estate is large enough at the time of your death.  For calender year 2019, the minimum required to be taxed with this is "$11,400,000," per the IRS.  Receiving policyowner dividends would not seem to constitute a collection of this tax.  However reception of the death benefit amount might.

State Estate Tax(es):  The individual states as well have their own estate taxes.  The tax foundation reports that about "fifteen states and the District of Columbia have an estate tax." Receiving policyowner dividends would not seem to constitute a collection of this tax.  However reception of the death benefit may. Of note with the states since often estate and inheritance transfer crosses multiple state lines you may need to check with multiple jurisdictions.

State Inheritance Tax(es):  The federal government of the United States "does not have an inheritance tax."  Inheritance taxes applies (generally) to the receiver of the estate. The "tax amount is calculated separately for each individual beneficiary, and the beneficiary must pay the tax."  According to that same TurboTax article: "six states that impose an inheritance tax include Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania."  So do life insurance dividends get taxed by these states?  See your tax professional. Of note with the states since often estate and inheritance transfer crosses multiple state lines you may need to check with multiple jurisdictions.

Foreign Taxes:  We make note of this as its always possible for certain individuals in certain situations.

Local Income, Estate, Inheritance Taxes:  Since New York City taxes individuals on income earned in their city its possible that various locals also charge estate and inheritance taxes. You would need to check with your tax adviser on this as well.

Other Taxes:  Quite frankly when it comes to tax law, no list is complete without an Other category. There are always other taxes out there, its impossible to list them all.

Future Taxes:  Things change.  Government officials find new ways to create revenue.

The most common reason that an individual could be forced to pay income tax on a life insurance contract dividend is when the interest received exceeds the annual premiums paid.  This makes good logical sense. The moment that the product is shown to actually be profitable you will be taxed. This though is not common, certainly early on in the contract life.

Another possibility is if you were to purchase a limited pay whole life insurance product such as a Single Premium Whole Life Insurance contract.  Or if a regular policy was over payed and thus triggering a Modified Endowment Contract, then I could imagine significant tax consequences.

If you were to cash in a whole life insurance contract, its possible that past dividends could then be thought of as requiring an income tax payment.  An example by Fox Business says this: "For example, you have paid in premiums totaling $10,000 and received dividends and rebates totaling $1,000. Your net investment is $9,000. Let’s say the proceeds are $20,000. After subtracting your $9,000 investment the difference of $11,000 will be taxable to you." The tax consequences with this is extremely complex.  Please speak with your tax specialist.

Another way that its possible that past dividends could come into play is if you were to sell your life insurance policy either as a viatical settlement or for financial need or gain.  The tax consequences with these is extremely complex.  Please speak with your tax person.

Business Life Insurance policies: If your business owns the insurance policy on someone else's life and receives whole life dividend payment, is it taxable? With business life insurance, its really less clear.

If Multiple parties are involved, such as those breaking the Goodman Triangle concept.  The Goodman Triangle, often also called the Unholy Trinity is when too many separate parties are participants on one insurer contract.  This can get overly complex.  But in general if the insured and the owner are not the same individual and a distinct entity is named as the beneficiary - tax consequences can take place.  This is usually a tax surprise for the recipient of the death benefit, but possibly it could affect the dividend recipient as well.

Future and unknown reasons:  There could always be either future legislation, Inruance regulatory changes, or other legal precedence that can change this situation.

There are undoubtedly more reasons that participating dividends could be taxed.

Of note here is that some forms of trusts used with life insurance policies such a Irrevocable Life Insurance Trusts  and other life insurance trusts may constitute a separate parties and hence have tax consequences.

See your tax specialist and provide them all of the insurance information as well as all of your other income information each and every year.