The IRS treats dividends on stock in a life insurance company different from dividends on a policy.
Life insurance provides money upon the death of an individual. Life insurance can be whole life, term or variations between the two. Whole life has cash value and normally level premiums throughout the life of the policy. The cash value offsets the increasing premiums as people age. Term policies normally don't have cash value; they have increasing premiums and end at a specified time, such as when the policyholder turns 65. Both types may give dividends.
Types of Companies
Life insurance companies exist in two forms, stock companies and mutual companies. Stockholders own the company in stock companies and the shares sell on the stock market exchanges. The policyholders own the mutual companies. When life insurance first became popular, many of the companies raised the money for the company through the sale of the policies. However, as tax laws changed, it became more beneficial for companies to sell stock to raise funds, and often companies bought out the policyholders' investment in the company by issuing stock in exchange for the policyholders' right to receive dividends.
Dividends
When a company makes profits, it returns some of them to the owners. If the company is a mutual company, it returns them to the policyholders in the form of dividends. If it's a stock company, the excess goes to the stockholders, also in the form of dividends. However, the two types of dividends are not treated the same under the IRS tax laws.
Losses
In the early days of insurance policies, the mutual companies often were nothing more than groups of people that banded together to share the burden of a loss. Most of the time, the company calculated the payment adequately so that the premiums they collected covered any losses for the year, and often there was some in surplus and some returned to the policyholders. However, if there were an inordinate amount of claims, the policyholders might be assessed an additional amount to cover the increased costs. If the company was a stock company, while the price of the shares might drop, stockholders never had to reach into their pockets to cover the cost.
Mutual vs. Stock Dividends
The IRS considers stock an investment and the dividends that the company gives you are gains on that investment. The entire goal for an investment, according to the regulations of the Internal Revenue Service, is to make money. When a mutual company gives the policyholders a dividend, the IRS considers the funds an overpayment of premiums, because if there were an underpayment, the policyholders would have to pay extra funds to support the mutual company.
Taxation of Dividends
When you receive dividends from stock, you pay tax on those dividends. A dividend in this case is money you make from an investment. When you receive dividends on a life insurance policy, the IRS says you received an overpayment of premiums as long as it's not more than you paid into the policy and you don't pay tax on those dividends. The government created the tax laws on dividends when many life insurance companies were nothing more than groups of people banding together to share the burden of a loss, so it was fair not to tax funds that were in excess and nothing more than overpayment. If you allow the dividends to accumulate and they gain interest, you pay tax on that interest.
