Permanent life insurance policies may offer cash value on top of the death benefit. Cash value is money that you can take out and spend while you are alive. Depending on your insurance company, you may also receive dividend payments on your permanent policy. The taxation of these dividends depends on how you handle your cash value withdrawals.
When a company makes a profit, it can pay out the profit to its owners through a cash or stock dividend. Usually, owners are shareholders that own preferred stock in a company. This is also true for life insurance companies that sell stock; however, some life insurance companies don't sell stock. Insurance companies that don't sell stock are called mutual life insurance companies. Instead of shareholders who own shares of stock in the insurance company, mutual life insurance companies are owned by their policyholders. If the mutual insurance company takes in more revenue than it pays out, it will return the profit to the policyholders through a policy dividend.
You have a few options when your life insurance receives a dividend. You can have the company mail you a check. You can also use the dividend to reduce the future premiums on your insurance policy. If you took out a loan from your insurance cash value, you can also use the dividend to pay off the loan. Lastly, you can reinvest the dividend to buy more life insurance. The more life insurance you own, the greater your total dividend. Reinvesting the dividend means you'll get more money in the future.
The IRS doesn't tax the gains on life insurance as long as the gains stay in the policy. If you use your dividend to buy more life insurance, pay off a loan or reduce your future premium, you won't owe any income tax. If you ask the company to mail you a check, you could owe taxes. You get your insurance premium payments back tax-free, so you won't owe any taxes as long as your total dividend payout is less than your total premium payments. If you receive more money from your policy than you paid in, you will owe income tax on the gains.
There is a way to take out your account dividends without paying income-tax. The IRS lets you take loans from your cash value tax-free, and you don't need to pay off your loan as long as you keep your policy active. If you never pay off the loan, your death benefit will pay it when you die. This lets you spend off your dividends without ever paying income tax. The downside of taking a policy loan is it will reduce the future death benefit for your heirs. If you want to restore the original death benefit, you'll need to pay your loan back with interest.
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