Are Life Insurance Dividends Reported as Income?
The life insurance company you do business with may offer to pay you a dividend. These dividends are normally only associated with mutual life insurance companies. The mutual life insurer is a type of insurance company that works for the benefit of policyholders. Because of this, the insurer pays dividends to the policyholders.
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Potential
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There are several ways that dividends can be accounted for in a life insurance policy. First, dividends may go toward buying additional life insurance. Secondly, dividends can be held with the company and earn interest. Third, dividends can be paid out as cash. Finally, dividends can be used to reduce the premium payment due on the policy. The only time dividends are reported as income is if or when they are paid out as cash and they exceed the total amount of premiums you've paid into the policy.
Significance
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The significance of dividends being reported as income is that the dividends are added to your gross income and included as investment income. Investment income is taxed at ordinary income tax rates. If your dividend amount is significant enough, you may be pushed into the next highest tax bracket. For all cases where you do not receive dividends as cash, your taxable income does not increase regardless of the dividend amount.
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Benefits
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The benefit of life insurance dividends is that as long as they stay in the policy, they are not reportable as income. You benefit from this because either the cash value of your life insurance policy increases or your dividend amount held with the company increases thus increasing your total assets and net worth. In cases where the dividends go toward paying for policy premiums, you are essentially receiving tax-free income to pay for policy premiums. In cases where dividends are held with the company at interest, you get the benefit of tax free investment capital. In instances where dividends buy additional insurance, you get the benefit of an income tax-free savings that can be used for any purpose throughout your lifetime via policy loans.
Drawbacks
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The drawback to dividends, when they are reportable as income, is that they increase your total tax liability. If you withdraw dividends and they exceed the total amount of money paid as premiums, the excess dividends over the total premium payments made to the policy is considered a gain. That gain is considered taxable income. For example, if you've paid $10,000 in premium payments, but the total amount of dividends you've cash in and withdrawn from the policy amounts to $20,000, then $10,000 of that dividend amount is taxable as income. Additionally, total dividends paid as cash are taxable as income if they exceed total premium payments made to the policy. Dividends held with the company to earn interest are not taxable as income, but any interest you earn on those dividends is taxable as investment income.
Misconceptions
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A common misconception is that life insurance dividends are never reportable as income. This is generally true, because the IRS regards dividends as a return of premiums paid. However, it is also possible for dividends to exceed premium payments made to the policy. When this happens, the life insurance policy dividends are treated as a gain. However, unlike regular dividend payments, which are taxed at capital-gains tax rates, life insurance dividends are taxed at ordinary income tax rates.
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