Please clarify life insurance bonus taxation differences (cash vs. reversionary)

Hi, this is a question from a student. Textbook is unclear, TA is not sure of the answer, Prof has not yet set office hours. This is not a question on my homework! We have been told there are cash, reversionary, and terminal bonuses from life insurance policies. My question is: what is the tax (US) treatment of each of these? Some sources say the IRS treats them all as refund on premiums - meaning they are not taxable income. Other sources say (textbook) reversionary is more tax efficient than cash - but why? Others yet say it depends on how these bonuses arise, and this is a point that is not even vaguely explained in the textbook.

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I am not sure, especially since I cannot see the textbook’s presentation, but here is something to think about that is probably related to what the textbook author had in mind: compound interest. I’m not a tax expert by any means, but my impression is that in the US all those dividends would not be taxable. If the policyholder eventually gets them they’re treated as a return of premium. If they are paid as part of a death benefit to the beneficiary, they’re death benefits, not return of premium, but still not taxable.

As a few simple example of the compound interest effect, suppose a young policyholder on a three-year endowment policy in the US could receive dividends of 100 a year at the end of each year, or could receive reversionary bonuses that would accumulate to 100 (1.03^2 + 1.03 + 1) or a terminal bonus of 100 (1.03^2 + 1.03 + 1). Suppose further that the policyholder can earn 3% interest on any dividends he collects in cash.

If he takes the cash dividends, he pays tax on interest earned each year, so at the end of three years he has 100 (1.03^2 + 1.03 + 1) less the taxes he had to pay on the interest he earned from the dividends.

Obviously a very important part of the analysis is the comparison on the interest he would earn tax-free inside the policy, compared to the possibly higher but taxable interest he would earn if he took the dividends and invested them. Also relevant is that normally reversionary dividends (especially, for example, on a whole life policy, but also on an endowment insurance) increase the death benefit, probably by more than the amount of the dividends. That extra life insurance has value to the policyholder, who might find the reversionary bonus more attractive, even if the after-tax endowment benefit on the policy with reversionary bonus is smaller than the after-tax result of the cash dividends accumulated with interest would be.

Thank you very much! This is a very good explanation.