Withdrawals on a Life Insurance Dividend
Cash value life insurance builds a cash reserve against the death benefit of the policy. Some cash value policies pay dividends. These are whole life insurance policies that are usually, but not always, sold by mutual life insurers. The dividends of the policy may be used to buy additional paid-up life insurance but may also be withdrawn if you need or want the money.
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Features
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Life insurance policy dividends go toward buying additional paid-up life insurance. The life insurance dividends accumulate in the policy on a tax-free basis. These dividends represent a return of premiums up to the amount of premium you've paid into the policy. Beyond this point, the policy dividends are considered a gain in the policy. Your premium payments are described as your "basis" in the policy. Dividends are paid based on favorable investment and mortality experience. Favorable investment experience means that the insurer has done well with its investments. Mortality experience refers to how many life insurance claims have been paid.
Effects
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When you cash in dividends, the policy's cash value and death benefit decreases by an equal amount. One dividend is equivalent to $1 of cash value. Once this dividend is removed, it normally cannot be put back into the policy. The only exception to this is if your whole life policy has a rider, an amendment attached to the policy that allows you to pay additional money to the policy beyond the contractually agreed premium amount. This rider is most commonly known as a paid-up additions rider.
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Benefit
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The benefit of cashing in the dividends of your policy is that the dividend amount you receive is tax free up to your basis in the policy. The IRS considers this a return of premium. You don't have to claim this amount on your tax return, which simplifies your filing.
Considerations
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Consider borrowing from the policy instead of withdrawing dividends. A policy loan allows you access to the dividends but does not remove them from the policy. Policy loans are tax-free as long as the policy remains in force. They do not need to be repaid on a set schedule either. Policy loans are charged interest. However, the insurance company will secure the loan you take against the policy using some of the cash value. An amount equal to your policy loan will be set aside and will earn interest. This interest may partially or completely offset the loan interest you pay to the insurer.
If you must withdraw dividends from the policy, be aware that money withdrawn in excess of your basis will be taxed as ordinary income and must be reported to the IRS on your tax return.
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