How dividends, premiums and basis interact for tax: a worked example

The tax result of almost every move you make with a whole life policy, whether a withdrawal, a surrender or a lapse, turns on one number: your cost basis. Basis is the part of the policy's value that the tax law treats as your own money coming back, and it is built from premiums and reduced by tax-free amounts you take out, including dividends paid to you in cash. Most owners never calculate it, and many insurers show it only on request. This post builds the number from scratch on a hypothetical policy, year by year, then applies it to a withdrawal, a surrender, a loan that goes wrong and a dividend that finally becomes taxable.

All figures are invented for illustration. The rules described are the general federal ones for a policy that is not a modified endowment contract; a tax professional should confirm how they apply to your policy and your state.

The rule in plain words

For a life insurance policy that meets the tax definition of life insurance, the investment gain inside the policy is not taxed while it stays there. When money comes out, the tax law asks how much of it is your own premiums returning and how much is gain.

• Basis (the tax law calls it investment in the contract) is generally the premiums you have paid, minus amounts you have received that were not taxable. The main reductions are dividends taken in cash and earlier withdrawals that came out tax-free.
• A dividend on a participating policy is generally treated as a partial return of premium, so it is not taxed when you take it in cash until the total you have received exceeds your basis. Interest the insurer pays on dividends left on deposit is taxable in the year it is credited.
• A withdrawal from an ordinary policy is generally taxed basis first: it is tax-free until total withdrawals equal basis, and the excess is ordinary income. (A reduction in death benefit in the first fifteen years can change the order, so ask before withdrawing from a young policy.)
• A loan is generally not a taxable distribution while the policy stays in force.
• A surrender or lapse produces ordinary income equal to the amount received, including any loan canceled, minus basis.

The guide on how cash value is taxed: withdrawals, loans and surrenders covers these rules with sources. Here they are put to work.

The hypothetical policy

Say a participating whole life policy is bought at age 40 with an annual premium of $6,000 payable for 20 years, after which it is paid up. The owner takes every dividend in cash. The dividends, invented for the example:

• Years 1 to 5: none.
• Years 6 to 10: $600 a year.
• Years 11 to 20: $1,500 a year.
• Years 21 onward: $4,000 a year (the policy is paid up and the dividends are larger).

Dividends are not guaranteed, and real ones do not follow a neat pattern. The simple pattern lets the arithmetic stay visible.

Building basis, year by year

Basis at any date is cumulative premiums minus cumulative dividends taken in cash.

Check each row. Year 10: five years of $600 is $3,000, and $60,000 - $3,000 = $57,000. Year 20: $3,000 plus ten years of $1,500 ($15,000) is $18,000, and $120,000 - $18,000 = $102,000. Year 30: ten more years of $4,000 adds $40,000, so $18,000 + $40,000 = $58,000, and $120,000 - $58,000 = $62,000. Year 45: twenty-five years of $4,000 from year 21 through year 45 is $100,000, so $18,000 + $100,000 = $118,000, and $120,000 - $118,000 = $2,000.

Two observations. First, premiums stop at year 20, so after that the only force acting on basis is dividends, and they push it down every year. Second, that is the sense in which cash dividends are "tax-free until they exceed what you paid": the exemption is used up as you take them.

When a dividend first becomes taxable

At the end of year 45 the basis is $2,000. The year-46 dividend is $4,000.

• The first $2,000 brings basis to zero and is a tax-free return of premium.
• The remaining $2,000 exceeds basis and is generally taxable as ordinary income.

Every dividend after that is fully taxable. Check: total premiums $120,000, total dividends through year 46 equal $118,000 + $4,000 = $122,000, and $122,000 - $120,000 = $2,000 of taxable excess. The owner, who bought the policy at 40, is 86 at the end of year 46. In practice few owners take dividends in cash for 46 years without using the cash value in other ways, but the arithmetic shows why the rule is a timing rule and not an exemption.

If the dividends were larger or the premiums smaller, the crossing would arrive sooner. An owner with a paid-up policy and substantial dividends should check the basis each year, and the insurer can supply the figure.

What changes if the dividends buy paid-up additions

Say instead that the owner uses each dividend to buy paid-up additions riders explained rather than taking cash. The general view is that the dividend is treated as received and then paid back in as premium for the addition, so basis does not fall as it did above; the net effect on basis is generally zero. After 20 years, basis is the $120,000 of premiums, not $102,000.

The trade-off is that a policy whose dividends stay inside it builds a larger cash value, and the gap between cash value and basis, which is the taxable gain, can widen faster. A higher basis helps only as long as the cash value does not outrun it by much. Where the dividend goes affects both the death benefit and the tax math, which is why life insurance dividend options: cash, paid-up additions and more is worth rereading before you change the default. How your insurer reports the amounts is a matter for the annual statement, and a tax professional should confirm how they affect your basis.

Dividends applied to reduce the premium work in a similar way: the premium counts as paid and the dividend as received, so the net is the out-of-pocket amount. With a $6,000 premium and a $1,500 dividend applied to it, the owner writes a check for $4,500, and the net addition to basis is $4,500 ($6,000 - $1,500).

Dividends left on deposit are a separate case, because the interest is taxable each year even if you reinvest it. Say $10,000 sits on deposit and the insurer credits interest at an illustrative 3 percent. That is $300 of taxable income for the year ($10,000 x 0.03), reported on a Form 1099-INT or similar, even though the owner never touched it. The deposit itself is not part of the policy's cash value. Ask how your insurer counts the deposit balance toward basis, and whether it pays the balance to the beneficiary at death in addition to the death benefit.

Case A: a withdrawal at year 20

At the end of year 20 the owner has a basis of $102,000. Say the cash value is $150,000. The owner needs money and withdraws $70,000.

• Basis comes first: the withdrawal is within the $102,000 basis, so the tax on it is $0.
• Basis after: $102,000 - $70,000 = $32,000.
• The withdrawal usually reduces the cash value to $80,000 and often reduces the death benefit as well, which the contract specifies.

Later the owner withdraws another $50,000.

• The first $32,000 is tax-free and uses up the remaining basis.
• The other $18,000 ($50,000 - $32,000) is ordinary income.
• Basis after: $0.

Check: total withdrawn is $120,000, basis was $102,000, so the taxable excess is $18,000. If the policy were a modified endowment contract the order would be reversed, with gain taxed first and a 10 percent additional tax possible before age 59½, a point treated in modified endowment contracts and the 7-pay test. Details on mechanics and effects on the death benefit are in withdrawing cash value from a life insurance policy.

Case B: a surrender at year 20

If the owner instead surrenders at the end of year 20 with a cash surrender value of $150,000 and no loan:

• Gain = $150,000 - $102,000 = $48,000, taxed as ordinary income.
• The insurer reports it on Form 1099-R.

If the cash surrender value were below basis, there would be no tax and no deduction for the loss. The comparison of keep, surrender and sell is the subject of the keep, surrender or sell your policy?.

Case C: a loan that outgrows the policy

Suppose the owner never takes a withdrawal but borrows against the policy over the years and lets the interest accrue. At the end of year 30 the basis is $62,000 and the cash value is $150,000. Say the loan balance, with interest, has grown to $150,000, equal to the cash value, and the policy lapses.

• Amount treated as received: the canceled loan of $150,000.
• Gain = $150,000 - $62,000 = $88,000, ordinary income.
• Cash received: none, since the insurer applied the cash value to the loan.

The owner faces a tax bill on $88,000 of income with no money to pay it and no insurance left. The loan itself was not taxed when taken, which is why the pattern looks attractive on the way in. It is the lapse that triggers the tax. The guide on life insurance policy loans: how they work and what they risk describes protective steps, and the planned post a lapse with an outstanding loan, worked through to the tax bill works one through year by year.

The fifteen-year rule and the MEC test

Two rules can disturb the order described above, and both are easy to trigger without noticing.

The first is the early-years rule. Federal law, in section 7702(f)(7), can require that a withdrawal that comes with a reduction in the death benefit during the first fifteen years be treated as coming from gain first rather than from basis first. The hypothetical owner above withdrew in year 20 and was clear of it. An owner who needs money in year 8 may not be. Before any early withdrawal, ask the insurer whether the rule applies and what the tax reporting will show.

The second is the modified endowment contract test. A policy funded faster than the seven-pay test allows is a MEC, and for a MEC the order flips: loans and withdrawals are taxed gain first, with a 10 percent additional tax possible before age 59½. A policy that begins as an ordinary contract can become a MEC after a material change, such as a large premium paid on top of the plan or an increase in coverage. Most traditional level-premium whole life policies sit comfortably below the limit, but a heavily funded design with a paid-up additions rider is built to approach it, and the buyer should confirm in writing where the line is. The guide on modified endowment contracts and the 7-pay test explains the test.

What basis does not tell you

Basis does not tell you whether to keep a policy. It tells you the tax price of leaving it. A high basis with a modest cash value, as at year 10 here, means a surrender is unlikely to be taxable but is likely to be a bad result economically, since the cash value is still below premiums paid. A low basis with a large cash value, as at year 30, means a surrender or lapse is expensive in tax, which makes alternatives such as a 1035 exchanges: swapping policies without tax, a reduced paid-up option or continued premiums worth a look.

Keeping the record

Basis is easy to maintain if you start early. Keep a one-page sheet, updated each policy anniversary:

1. Premiums paid this year, including any paid by dividends or by a premium loan.
2. Dividends received in cash and how the rest was used.
3. Withdrawals and their tax treatment.
4. Loan balance and interest.
5. The basis figure the insurer reports, if it provides one.

Compare your sheet with the insurer's figure. They can differ for reasons such as rider charges or how the insurer treats dividend deposits, and a discrepancy is worth a question. For a policy you inherited, or one that has been exchanged, the figure can be harder to reconstruct, and the planned post figuring your cost basis in a cash value policy before any withdrawal goes further on the calculation.

A short list of questions for the insurer

When you call to get the basis figure, a few specific questions save a second call.

1. What is the total premium paid to date, and how much of that came from dividends or premium loans?
2. How much in dividends have I received in cash, and how much has been used for additions, premium or deposit?
3. What is my investment in the contract as you would report it on a Form 1099-R today?
4. Has any withdrawal or partial surrender been made, and how was it reported?
5. Is the policy a modified endowment contract, and has it ever failed the seven-pay test?
6. If I took a $10,000 withdrawal or loan today, what would the tax reporting show?

Write down the date and the answers. If the insurer cannot answer clearly, ask for it in writing.

When to get help

A tax professional should look at any surrender, large withdrawal or lapse before it happens, and any policy that may be a modified endowment contract. The insurer's service department can supply premium and dividend histories, and the Form 1099-R it issues is the tax document that shows the result. Nothing here replaces that review, since individual facts such as riders, 1035 exchanges and state tax treatment can change the answer.

Key takeaways

• Basis is generally premiums paid minus tax-free amounts received, including dividends taken in cash and earlier withdrawals.
• Cash dividends are a tax-free return of premium until their total passes basis, and the example shows basis falling to $2,000 by year 45 before the first taxable dollar appears.
• Dividends used to buy paid-up additions or reduce premiums generally leave basis unchanged, because the money is treated as received and paid back in.
• An ordinary policy's withdrawals come out basis first, so $120,000 withdrawn against $102,000 of basis produces $18,000 of income.
• A lapse or surrender with a loan counts the canceled loan as received, so $150,000 against a $62,000 basis creates $88,000 of income with no cash.