Life insurance dividends are paid out to participating life policies when insurance companies earn excess profits after claims and operating costs are covered.
While purchasing term life insurance is a preferable choice to whole for most people, whole life insurance comes with a number of unique benefits.
Life insurance dividends, also known as a return of excess premium, is one of them.
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Life insurance dividends actually bear a close resemblance to the dividends you would receive from any other type of investment, where you share in the returns of the company you invested in.
Dividends can be determined differently for privately held companies (called stock companies) and mutual companies, and policyholders have a number of options for how to use their life insurance dividends.
Dividend amounts also can change each year and are not guaranteed. And dividend-paying whole life insurance policies tend to charge higher premiums.
How much money you earn in dividends depends on how much you pay into your policy.
While premiums can get pretty costly with whole life, the dividend amount can grow over time, alleviating some of the weight of your premium costs.
True whole life insurance policies usually pay dividends, but this type of permanent coverage can be either participating or non-participating.
That is why it is critical to do your research before selecting a life insurance company and policy.
Just because a policy is whole life does not mean it is guaranteed to pay dividends.
Reading the policy carefully is key to ensuring you understand the terms of your plan’s coverage and its potential benefits.
Likewise, you should remember this investment, like most, does not guarantee a return.
Your life insurance provider may end up with a substantial surplus one year and none the next – this can directly impact whether you get a dividend or not.
If you’re buying a whole life policy because of the certainty that comes with it, you’ll be in excellent shape in terms of the cash value and death benefit you receive.
These are usually guaranteed statements within the contract.
You shouldn’t, however, depend on dividend returns with the same amount of certainty.
You may be wondering how different types of insurance companies handle dividends.
Mutual and private life insurance companies offer dividends under different circumstances, which could significantly impact your payout.
First, you should understand mutual life insurance companies are owned by their policyholders.
Policyholder premiums are calculated to cover operating expenses, claims, and unforeseen costs.
If there are surplus profits at the end of the fiscal year, a dividend is declared and is split between policyholders with participating whole life insurance policies.
With stock or private life insurance companies, participating policies offer a benefit similar to holding stock in the company.
If the company’s investments do well and the stock price rises, a dividend is declared and shareholders and participating policyholders share in the profits.
If the company’s stock falls, shareholders lose money but eligible policyholders do not lose their investment—they simply do not receive a dividend that year.
Your dividend is paid out on the annual policy anniversary (the date it was purchased) the year after which the dividend was earned.
While it is a set standard across life insurance companies, the way you receive your dividends is up to you.
Policy dividends can be paid out in four main ways, and you have the choice to pick which method makes the most financial sense for you.
- Cash: The insurance company sends you a check for the dividend amount.
- Premium Payments: Your dividend can cover and pre-pay your premium.
- Savings: Dividends may be deposited in your policy’s cash value and allowed to earn interest.
- Increased Coverage: Dividends added to your policy’s cash value may be used to buy paid-up coverage that increases your death benefit.
You can use your own financial goals to determine which type of payout to opt for, though many elect to have the dividends go into the policy cash value to continue to grow.
If saving money for the future is your overall goal, then you could use your money to pay your premiums, offsetting the cost or covering it all together, or buy even more insurance.
If you have no need for the money today and wish for the dividend payment to benefit your loved ones later, you could add the dividend to your policy’s cash value, letting it accumulate interest alongside those funds.
Since your dividend is usually calculated as a percentage of your current cash value, it is important to note outstanding loans and withdrawals using your cash value as collateral will reduce dividend payments.
Let’s take a look at a specific scenario to gain a deeper understanding of how cash value can affect your dividend payout:
If your current cash value is $50,000 and the dividend yield is 3.5%, your payout would be $1,750.
However, if your previous cash value was $50,000 and you’ve recently requested a $25,000 low-interest loan, your earnings will be $875.
On the other hand, if you consistently reinvest your dividends into the cash value, your distributions can grow year-over-year.
The growth of your returns can be considerable after years of continuous reinvestment.
And keep in mind interest earned on your cash value is tax-deferred, so a participating policy can have significant tax advantages for some families.
If life insurance dividends are used to pre-pay premiums, they are added to the cash value and may be used to buy paid-up additions to your whole life insurance policy, which increase its death benefit.
In this way, dividends would not be subject to income tax because distributions are not made directly to you (and the resulting added death benefit is also not taxable when you die).
If the amount of the dividend is less than your insurance premiums for the year, dividends are considered a return of premium and are not taxable.
The IRS essentially treats the dividend as a refund for overpayment of premiums through the year.
In the event the dividend exceeds the yearly premium, the amount in excess of the premium is taxable as income and applied as a life insurance tax.
So, if you paid $1,500 in premiums and your dividend balance is $2,000, the $500 difference is taxable income.
If dividend-paying whole life insurance is a part of your financial plan, you should thoroughly research to find the best life insurance company who fits your needs.
The company should be financially-stable (minimum “A” rating) with a history of paying dividends regularly.
In the end, there are many pros and cons of participating whole life policies.
Before buying coverage, make sure you review your financial needs and investment options to decide if life insurance dividends are essential to your financial plan.