Some life insurance policies offer policyholders an option to receive dividends if the insurance carrier’s earnings exceed a set amount. If you’re thinking about getting whole life insurance coverage, you need to decide whether to choose a dividend-paying policy. These unique policy types can provide you with lifetime insurance coverage, cash value, and annual dividends. However, there are also some potential drawbacks.
Before making your decision, take time to understand the details of how dividends in life insurance actually work.
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What Are Life Insurance Dividends and How Do They Work?
Life insurance dividends are annual payments that are distributed to owners of certain types of life insurance policies. These payments represent a return of premium and are paid when the insurance carrier earns excess profits for the year. Generally, the amount of dividends you receive is based on how much you pay into your policy. As a policy owner, these dividends can allow you to participate in the carrier’s profits.
A dividend-paying whole life insurance policy offers lifetime insurance coverage as long as your premiums are paid. These policies work like other types of whole life insurance policies, except that they pay out dividends to the policy owners.
The Dividend Scale
A dividend scale is a figure life insurance companies use to determine the amount of dividends it pays out to policyholders. It reflects both the current year’s payment and the anticipated amount to be paid in future years. Dividend scales are typically created by an actuary and are used as a system to fairly distribute annual dividends based on each policy’s class and terms.
The dividend scale is typically reviewed each year and can change depending on a variety of factors, known as the company’s operating experience. Factors that may impact the dividend scale include current interest rates, the company’s expenses, the number of death claims on similar policies, investment returns, and even changes in the tax code. As these factors change, they can cause the amount of each year’s dividend to change as well. If the changes are significant enough, the company may adopt a new dividend scale.
Do Dividends Affect Your Policy’s Cash Value and Death Benefit?
The impact of dividend payments on your policy’s cash value and death benefit can vary depending on which payment option you choose. If you elect to reinvest your cash dividends, they accumulate interest at a specified rate. Making this selection can result in an increase in both your death benefit and the cash value of your policy. If you decide to let your dividends accumulate, you can also withdraw them at any time without impacting your cash value or your guaranteed death benefit.
Choosing to use your dividends to purchase additional paid-up insurance increases your policy’s death benefit. If you pass away with an accumulated interest in your policy, this is added to the cash value and distributed along with your policy’s face-value death benefit. You can also use your dividends to pay down outstanding loans, which could reduce the amount that is deducted from your death benefit if you die before your loan is fully paid off.
What Kinds of Policies Pay Dividends In Life Insurance?
The type of insurance policy that pays dividends is known as a dividend-paying whole life insurance policy. It’s important to note that not all whole life policies pay dividends. Instead, they are categorized as either participating or non-participating, with participating policies paying dividends while non-participating policies do not.
When evaluating a life insurance policy for potential dividend payments, it’s also important to note whether the carrier is a mutual life insurance company or a private insurance company. Mutual life insurance companies are owned by the policy owners. With these types of policies, when there is a surplus in profits at the end of the fiscal year, the company declares a dividend and splits it among the owners of its participating whole life policies. Unlike private insurance carriers, mutual insurance companies are required by law to distribute their excess profits each year.
What Kinds of Policies Have No Life Insurance Dividends?
Typically, participating whole life insurance policies pay dividends. Other types of life insurance, including non-participating whole life, term life, traditional universal life, and variable universal life insurance policies, do not pay dividends.
How Are Life Insurance Dividends Calculated?
The methods for calculating dividends on life insurance can vary depending on the carrier and the policy. The details are typically proprietary. In general, they are based on a carrier’s excess profits.
An insurance policy’s annual premium payments are calculated to cover the company’s claims, expenses, reserve requirements, contractual obligations, and unforeseen costs. If there is a surplus of funds at the end of the fiscal year after these costs have been covered, the company typically uses the excess amount as a basis for calculating the dividend. Dividends are declared annually and are typically paid out once a year on the contract anniversary date.
How Taxes Work on Life Insurance Dividends
The IRS considers life insurance dividends to be a return of premium, so they are generally not taxable. This is true whether you leave them invested with the insurance company, take them out in cash, or use them to purchase additional life insurance coverage.
However, there is an exception. If the amount of your annual dividend is more than your premiums for the year, the excess is taxable as income. For example, if your annual premium is $1,500 and your dividend was $2,000, then the $1,500 is considered a tax-free return of premium, and the extra $500 is taxable income. If you leave your dividends invested inside your policy, the interest earned on the investment is also considered taxable income.
How Loans Affect Your Life Insurance Dividends
Whole life insurance policies have a cash value, which policy owners can borrow against while the policy is in force. Depending on the type of policy you own, outstanding policy loans could impact the amount of dividends you earn. Some policies calculate dividends using a direct recognition method, which adjusts the policy’s dividend based on the amount of loan funds they are unable to directly invest.
For example, if your carrier earns a 10% return on its investments and your loan rate is 8%, then the company adjusts the dividend down to reflect the loan amount it was unable to invest. On the other hand, if the company earns only 6% and your loan rate is 8%, the dividend is adjusted up to reflect the excess value your policy loan generated for the carrier that year.
Life Insurance Payout Options
When a life insurance carrier declares a dividend, the policy owner has several options regarding what to do with their payout. While the following list is not exhaustive, it explains some options that are commonly selected.
Cash
You can elect to have the insurance carrier send you a check for the dividend amount each year on your policy anniversary date. Although dividends are not guaranteed, many companies strive to pay them consistently, so choosing this option can be a way for you to generate additional income. As long as the dividends do not exceed your annual premium amount, they are not considered taxable income. However, if they do exceed your premiums, you owe taxes on the excess amount.
Paid-up Additional Insurance
Some policy owners use their dividends to purchase paid-up additional insurance, which increases your death benefit. Much like your base policy, these amounts are also eligible to earn dividends and build cash value. The value can grow cash-deferred inside your policy and further increase your death benefit.
Policy owners may sometimes use this option to optimize their growth and hold onto the excess funds to use for emergencies or when opportunities arise. If you earn dividends that are more than your annual premium and you use them to buy paid-up additional insurance, the excess is not taxable because it remains part of your policy’s cash value.
Reduced Premiums
You may be able to use your dividends to lower the out-of-pocket premium payments for your insurance policy. For example, if your annual payment is $600 and you receive a dividend of $150, you could apply the dividend to the premium due. In this case, your amount owed is only $450.
This option is typically available for policy owners who pay their premiums annually, semiannually, or quarterly. Since dividends are credited once per year, the amount you receive typically applies to the bill that’s due on the policy anniversary. If your dividend is higher than your annual premium amount, you may be able to use it to pay the entire premium and then choose one of the other options for the remaining balance.
Accumulate at Interest
Policy owners who elect to accumulate at interest choose to leave their dividends inside the policy, allowing them to earn interest at a rate specified by the insurance carrier. This works similarly to a savings account. If you choose this option, you can withdraw the dividends at any time without negatively impacting your policy and without owing taxes.
The interest you earn on your accumulated dividends is taxable in the year they are credited and may also be subject to tax withholding. Once you withdraw your accumulated dividends, you cannot put the funds back into the policy. If the covered individual dies and there are funds that have been accumulated, they may be paid out as a death benefit in addition to the face amount of the policy.
Reduce Policy Loan Balances
Policy owners who have outstanding loans can elect to use their annual dividends to pay down the balance. This can reduce or may even eliminate the need for you to use out-of-pocket cash to make your policy loan payments.
The Pros and Cons of Getting a Policy With Life Insurance Dividends
If you’re wondering whether it’s a good choice for you to get a dividend-paying whole life insurance policy, there are several important pros and cons to consider. Here’s a look at some of the factors that may impact your decision.
Pros
Although they’re not guaranteed, life insurance dividend payments are typically reliable. This, combined with their favorable tax nature, can make them a good way to generate additional income. They’re also very flexible, allowing you to decide what you want to do with the dividends each year.
Choosing a life insurance policy that pays dividends may help you maximize your policy benefits. For example, you could use the funds to cover all or a portion of your premium payments so you can pay less out of pocket each year. Purchasing paid-up additional insurance may also allow you to start with an affordable death benefit and use your dividends to increase it each year. As you accumulate values within your policy, the dividends can also grow over time, offsetting some of your premium costs.
Cons
Premiums for a dividend-paying policy may be significantly higher than non-participating whole-life policies, universal life policies, and term life insurance policies. These policies can also be somewhat complex, which could be a problem for some policy owners.
Since life insurance dividends are not guaranteed, you may also want to use caution when including these payments in your annual budget. It’s entirely possible for an insurance carrier to have significant profits to distribute one year and none the next. For this reason, you also cannot assume that dividends will cover all or part of your annual policy premiums or depend on them to purchase additional paid-up insurance each year. In addition, if your policy pays dividends beyond your premiums, you may end up with some tax liability. While this is typically not a significant problem, it is something to remain aware of.