Are life insurance dividends taxable?

There are a lot of misconceptions and, worse, just plain wrong information about the tax implications for life insurance.

Let me say this upfront: I’m not a tax professional. You should never make an important decision with taxes without talking to a professional, like a licensed insurance agent or financial advisor. Trust me, the peace of mind in making a good decision can’t be overstated.

That said, I’ve been bouncing around in the life insurance world for a while, and there may be a couple of things you learn in this article that may surprise you. It’s also a quick read.

So, let’s get to it.

Are there tax benefits to owning a life insurance policy?

Yes, there are definitely tax benefits to life insurance coverage. I get this question all the time, and I love answering it.

The benefits of life insurance are often tax-free. That’s a pretty big benefit, wouldn’t you say?

Let’s take a quick run through the most important things I get questions about:

• Death Benefit. This is typically tax-free. So, if your life insurance coverage amount is $500,000 and your spouse is the beneficiary, he or she will likely get the full amount income tax-free. The life insurance proceeds can be taken as a lump sum or through installments over time by working directly with the insurance company.
• Cash Value Growth. Permanent life insurance policies, such as whole life insurance or universal life insurance, accumulate cash value over time, which is generally tax-deferred. Policyholders won't be taxed on the gains as long as the policy remains in force.
• Policy Loans. If the policyholder takes a loan against a cash-value life insurance policy, the loan proceeds are typically tax-free. Policy loans can provide a source of tax-free income, allowing policyholders to access funds without triggering immediate tax consequences.
• No Capital Gains Tax on Death Benefit. Unlike many other investment vehicles, the death benefit from a life insurance policy is not subject to capital gains tax. This can be advantageous for individuals who hold policies with significant cash value or investment components.
• Estate Tax Planning. Life insurance can be used as a tool for estate tax planning. By carefully structuring ownership and beneficiaries, policyholders may be able to minimize estate taxes. For example, creating an Irrevocable Life Insurance Trust (ILIT) can help remove the life insurance death benefit from the insured person's taxable estate.

Answering your common questions about taxes and life insurance

Are life insurance dividends taxable?

Typically not. Dividends with life insurance are a component of a mutual life insurance company’s relationship with its policyholders. Since policyholders are considered partial owners of the mutual company, these dividends are typically treated as a return of premium paid rather than income.

Are life insurance premiums tax deductible?

No, in most cases. The premiums paid for a personal life insurance policy are considered a personal expense rather than a deductible business expense. This applies to both term life insurance and permanent life insurance policies. There may be situations in a business arrangement where the life insurance premium is tax deductible.

How do I avoid tax on life insurance?

The types of life insurance that most individuals purchase provide either tax-free or tax-deferred benefits. Honestly, there’s not much most of you have to worry about. There are also many valuable features of life insurance that you can take advantage of with no tax consequences:

• Tax-Free Policy Loans. If you plan to pull funds from your insurance policy (permanent policies like whole life insurance only), consider taking a loan rather than a withdrawal.
• Tax-Free Accelerated Death Benefits. Some life insurance policies offer benefits that allow the policy owner to receive a portion of the life insurance payout for their loved ones if they are diagnosed with a terminal or critical illness.
• Irrevocable Life Insurance Trust (ILIT). Having your life insurance in this type of trust can help minimize estate taxes by removing it from your taxable estate.

What is a Modified Endowment Contract (MEC)?

A MEC is a cash-value life insurance policy that no longer has some tax benefits because the policy owner has paid more premium payments and accumulated more cash in the policy than is allowable under IRS guidelines. Some people use this approach because it may provide better returns with lower risk than a savings account.

You can never be too careful when dealing with taxes.

Life insurance on its own requires (in my humble opinion) having a licensed insurance agent or trusted financial advisor at your side when making the decision.

Adding a complex subject like taxes to the discussion–even if it appears most life insurance products don’t have many tax implications–absolutely requires help from a professional.