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.

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. Please call me for more details if you’re considering making any major changes to your existing insurance policies, or if you have any further questions about the taxation of life insurance dividends and other lifetime distributions.