“Currently, ordinary dividends and short-term capital gains on assets held less than one year are subject to income tax.”[i] But life insurance dividends are different.
First of all, dividends paid on life insurance are only available to you if you own participating whole life insurance. And the number one thing that you need to know about those dividends is that they are not subject to taxes if you direct the insurance company to purchase more paid-up insurance (insurance completely owned by the policy holder). In fact, by choosing this option for your dividend payout you will increase your capacity to share in future dividends paid by the company because your participation in the company dividend is predicated on how much paid-up insurance you own. (It’s a snowball effect.)
Life insurance growth is taxed on a “first in first out” (FIFO) basis. And so, when you begin to withdraw money from your life insurance policy you will face NO taxes until you have withdrawn more money than what you have spent on premiums (cost basis). However, if you choose to borrow money against your life insurance, instead of withdrawing money from it, the current tax law classifies a loan from your policy like any other loan. Loans are not considered income or capital gains under the current Internal Revenue Code, and therefore, remain non-taxable.
In fact, if you borrow money against your life insurance for an investment purpose or a business expense, then the interest you pay to the insurance company even becomes a tax deduction for you personally. And paying that interest to the insurance company increases their profit from what it would have been if you hadn’t borrowed that money from them. This, overtime, could prove beneficial to you because dividends are based on the insurance company’s profits, minus mortality costs, minus expenses to run the company and the greater their profit the greater their dividend will be.
The bottom line is this.
The number one thing you need to know about life insurance dividends is that they are not taxable if you apply the right option.
And secondly, it is better to receive dividends than not to receive them. Finally, the only way you can earn and receive life insurance dividends is to own participating whole life insurance. You can’t earn dividends by owning universal life, variable universal life, indexed universal life, term insurance or even plain whole life insurance. You must own participating whole life insurance if you want to benefit from the growth, the access to money and all the tax benefits that dividends provide you as a policy owner.
Don’t pay more in taxes than you absolutely have to pay. “Over and over again the courts have said that there is nothing sinister in so arranging one’s affair as to keep taxes as low as possible. Everybody does so, rich and poor alike; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions.”[ii]
So, if you desire to so arrange your affairs to make your tax liability as low as possible, owning participating whole life insurance is one financial tool that can help you. If you don’t mind paying more in taxes than you have to pay, then you most likely wouldn’t value owning the only life insurance that pays you dividends.
[ii] Commissioner v. Newman 159 F.2d 848 (2d Cir. 1947)