Taxability of a Whole Life Annuity Policy

Annuitizing whole life policies helps supplement retirees income streams.

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Whole life insurance provides policyholders with cash value that grows over the course of the policy. Some insurance companies offer policyholders the ability to convert the cash value of their whole life insurance into an annuity, changing coverage they might no longer need into a stream of income. While the cash value in the policy grows tax-deferred, a portion of each whole life annuity payment is taxable.

Whole Life Tax Treatment

You purchase whole life insurance using after-tax cash and you cannot use pre-tax money under any circumstances. Depending on the returns offered by the insurance company, the cash value in the policy at some point might be greater than the total premiums paid. You report that growth as income only when it is pulled out of the policy. Converting the whole life policy into an annuity pulls the cash value out over a series of periodic payments.

General Rule for Annuities

A whole life annuity policy contains both after-tax dollars and pre-tax growth. While tax rules account for this mixture of pre- and post-tax dollars in the same vehicle on a last-in, first-out basis for single transactions, the general rule for annuities prescribes a different way of determining the taxability of a withdrawal. You recover the already-taxed basis evenly over the periodic payments through the use of the exclusion ratio. The exclusion ratio is calculated by dividing the amount of after-tax dollars in the policy by the anticipated payout, which is determined according to the annuitant’s age and a table set by the IRS.

Impact of Dividends

If a whole life plan receives dividends – called a participating plan – those dividends will impact the amount of after-tax dollars in the policy. Tax laws consider dividends as a return of premium, so they aren’t taxable, because they were paid using after-tax dollars. So when calculating the amount of after-tax dollars in a policy, multiplying the premiums by the number of premiums paid might overstate the basis if the policy pays dividends. The insurance company is responsible for keeping these records and can provide policy owners with their basis on request.

Dividend Options

Dividends are returns of premium, which typically reduces how much the policyholder paid for the insurance. However, many insurance companies offer several options for how policyholders can receive their dividends in addition to cutting a check. Some provide the option of leaving the dividend on deposit, earning interest, with the insurance company. The interest earned is taxable as it is earned, and if the deposit is put toward buying the annuity, then it will increase the after-tax dollars in the policy. Others might also offer the option of purchasing additional whole life insurance, in which case the dividend typically doesn’t impact the after-tax dollars in the policy.