A life insurance dividend is a non-guaranteed payment from the insurance company to the policyholder representing the earnings the company earned during the policy year. Insurance companies often view dividends as a distribution of the surplus created by their insurance activities to policyholders whose insurance contracts generate profits beyond the insurer’s expectations.
Technically, a dividend also represents a refund of the premiums paid by the policyholder for their insurance. In essence, the tax law that governs insurance allows the insurer to return the premiums paid by the policyholder because it turns out that the insurer did not need all the premiums paid to provide the insurance protection under the contract. This premium refund also has some tax implications, which we’ll discuss a bit later in this article.
Not all life insurance policies can earn dividends for the policyholder. the insurance contract must be a participating policy to provide the opportunity to earn dividends. If the policy is participative and the insurance company chooses to pay a dividend to the insured, then the insured could earn a dividend depending on the profitability of their type of insurance policy.
what do you do with the life insurance dividends?
The options you have regarding dividends earned on a life insurance policy will depend on the type of life insurance policy you own. Whole life insurance policies will have the most options. In fact, whole life insurance is the most common type of life insurance to earn dividends.
While much less common, term life and universal life insurance policies can also pay dividends.
Two dividend options universally available for all types of life insurance policies are cash payment and premium reduction/payment.
If you choose the dividend option as a cash payment, the insurance company will simply send you a check when it pays your dividend to policyholders. then you are free to do what you want with the money.
The option to reduce/pay the premium with the dividend will partially offset or fully pay for the premium owed on your life insurance policy. If the dividend is less than the premium due on your policy, this option will reduce the premium you pay. once the company applies the dividend to your premium, you will be responsible for the rest. If the dividend is large enough to cover the entire premium, you will pay nothing out of pocket for your life insurance. this situation can continue as long as the dividend paid by the insurance company does not decrease. If the dividend is more than your premium due, you can choose a different dividend option for the remaining amount. It is very common for the insurance company to require you to pay your premium annually if you choose this dividend option.
Other dividend options unique to permanent life insurance are: purchase paid add-ons, accumulate at interest, and purchase additional term life insurance >
The option to buy paid add-ons is typically a default dividend option for whole life insurance policies. This option uses your dividend to purchase additional paid immediately whole life policies that are attached to your original whole life policy. These additions can generate dividends on their own, and this acts as a way to compound the cash value of the entire life and death benefit.
The option to accrue at interest places the dividend in an interest-paying account that will act as a kind of savings account. the insurance company will pay regular interest on the cash in the account. you are free to withdraw money from the account whenever you want, but you cannot put additional money into the account; only dividend payments can go to the account. It’s important to understand that this savings-like account is outside of your whole life policy, meaning you don’t benefit from the whole life cash value tax-friendly features. It’s also important to understand that these accounts are generally uninsured for depositors (ie, fdic or ncua coverage).
The option to purchase additional death benefit coverage through term life insurance uses the dividend to purchase term life insurance for the policyholder. this feature can provide a higher death benefit amount than can be provided by whole life insurance with the same premium amount.
How often are life insurance dividends paid?
Generally speaking, life insurers pay dividends to policyholders once a year on the anniversary date of the policy. however, in less common situations, an insurer may pay a terminal dividend when an insured dies or when a policy owner cancels a policy. In this situation, it is possible to receive two different dividend payments. once for the regular dividend and then again for the terminal dividend.
how are dividends calculated?
The specific calculation of a dividend is complex and often a closely guarded trade secret among life insurers. however, there are important components used by all insurers that capture the intent of a dividend paid to a life insurance policyholder.
The three main components of a life insurance dividend come from insurers:
- technical benefits
- investment earnings
- benefit budgeting
Underwriting benefits come from being an insurance company. it is essentially a profit created when an insurer pays out fewer claims than anticipated. The insurer now has more money available from premium collections than she thought she needed to cover all paid claims.
Investment gains occur when the insurer generates returns on the assets it purchases to back the guarantees it offers under its life insurance contracts that exceed the guaranteed features of those contracts. Thus, if an insurer needs a 4% return to cover policyholder obligations, but generates 5% on its invested assets, the insurer now makes a profit on the returns it achieved in excess of those needed to provide the policyholders. benefits guaranteed by the policy.
Budgeting benefits arises when the insurer operates under budget. This might look like the insurer budgeting a certain amount for the labor needed to run the business, but at the end of the year she finds that only 90% of the budgeted money is spent for this purpose. it is rare that this component adds much to the overall dividend payout as budgets tend to be very accurate.
can dividends be withdrawn from life insurance?
If you have permanent life insurance and use your dividends to buy paid-up additions, you may decide to take those paid-up additions off the policy. insurance companies sometimes refer to this as delivery/withdrawal of dividend additions.
technically you are not withdrawing the dividend per se, because you used the dividend to buy paid additions. but the paid-up additions money exists because of the dividend, so you might consider storing the dividend in your policy through this feature and then withdrawing the dividend at a later date.
Doing this could mean you end up with more money than the original dividend amount. This happens because the paid additions will earn guaranteed contract interest, as well as dividends, if payable.
Do you have to pay taxes on life insurance dividends?
The taxability of life insurance dividends is more a question of when than if. I am not implying that all life insurance dividends become taxable. instead, I mean that there are circumstances in which dividends are taxable and in which they are not. the vast majority of the time they are not taxable.
But you should know that because dividends are a refund of premium, they reduce your policy’s cost basis if you take them out of the policy. this could eventually mean that you will pay taxes on future dividends and/or that withdrawing cash from your policy will be taxable if withdrawn.
are dividends guaranteed?
Life insurance dividends are not guaranteed. they are paid at the discretion of the life insurance company and life insurers do not guarantee dividends. They can and do change. This means that the amount of dividend received this year may be more or less than the dividend payment received next year. There is no promise from the insurance company regarding a specific amount of dividends paid or that it will pay any dividends in any given policy year.
But it’s also worth understanding that most insurance companies that currently pay dividends to policyholders have been making these payments for many years (some more than 100 consecutive years). These companies take the payment of dividends very seriously and there are insurance laws that mandate the payment of dividends when there are earnings for the participating life insurance types.