22 / Are dividends payable on a participating life insurance policy taxable income?

As a general rule, all dividends paid or credited before the maturity or surrender of a contract are tax-exempt as return of investment until an amount equal to the policyholder’s basis has been recovered. More specifically, when aggregate dividends plus all other amounts that have been received tax-free under the contract exceed aggregate gross premiums, the excess is taxable income.¹

It is immaterial whether dividends are taken in cash, applied against current premiums, used to purchase paid-up additions, or left with the insurance company to accumulate interest. Thus, accumulated dividends are not taxable either currently or when withdrawn (but the interest on accumulated dividends is taxable ( Q 23)) until aggregate dividends plus all other amounts that have been received tax-free under the contract exceed aggregate gross premiums. At that point, the excess is taxable income.² It is immaterial whether the policy is premium-paying or paid-up. However, dividends paid on life insurance policies that are classified as modified endowment contracts under IRC Section 7702A may be taxed differently).

Dividends are considered to be a partial return of basis; hence they reduce the cost basis of the contract. This reduction in cost must be taken into account in computing gain or loss upon the sale, surrender, exchange, or lifetime maturity of a contract ( Q 531).

1.     IRC § 72(e)(5); Treas. Reg. § 1.72-11(b)(1).