Dividends are considered the result of favorable insurer experience in mortality, income, and loading that make possible a return of a policyowner’s outlay and are usually income tax free. Until total dividends received exceed the policyowner’s cost, whether or not the policy is paid up, these distributions are income tax free regardless of whether received in the form of cash, used to purchase paid-up additions, one year term insurance, or left to accumulate at interest. But any interest earned under this last alternative will be taxable in the year it is earned.
Once dividends, together with any other nontaxable distributions, exceed the premiums paid by the policyowner, the excess is taxable each year at ordinary income rates. In other words, once a policyowner has recovered his investment in the contract (generally total premiums less any tax-free distributions received), dividends-as well as any other distributions are taxable as ordinary income.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM