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Will I be taxed on the growth of the cash value of my life insurance? What if my policy pays dividends?

One of the advantages of cash value life insurance is that the cash value is allowed to grow without incurring a current tax liability. In general, the cash value is allowed to grow on a tax-deferred basis until one of the following events occurs:

  • The policy is surrendered--you cash it in
  • The policy is transferred for value--you sell it or assign it, etc.
  • The policy ceases to meet the IRS definition of a life insurance contract

Typically, there is no tax liability until one of these events occurs because of the substantial limitations and restrictions on receiving distributions from the cash value.

Some life insurance policies (known as participating policies) pay dividends to their policyholders. Dividends are generally not taxed as income to you. Instead, they are considered a return of your premium regardless of whether you receive them in cash, use them to purchase additional coverage, use them to reduce future premiums, or leave them invested with the insurance company. However, if your dividends exceed the total premium payments for the insurance policy, the excess dividends are considered taxable income. If you leave your dividends invested with the insurance company, the interest earned on this investment will be considered taxable income.