What Are Dividends in Whole Life Insurance?
Gain a clear understanding of whole life insurance dividends: their nature, how they're used, and what influences their payment.
Whole life insurance is a type of permanent life insurance that includes a guaranteed death benefit and a cash value component that accumulates over time. Some whole life policies also offer the potential to receive dividends. These dividends are not guaranteed but represent a share of the insurance company’s financial success, enhancing the policy’s value for policyholders.
Understanding Whole Life Insurance Dividends
Whole life insurance dividends are a portion of an insurance company’s divisible surplus, which is shared with policyholders who own “participating” policies. This surplus arises when the company’s actual financial performance exceeds the conservative assumptions used to set premiums and guarantees. Dividends are declared annually by the insurer’s board of directors and are not guaranteed payments, as they depend on the company’s operating experience.
The divisible surplus typically stems from three main areas: lower mortality rates than expected (fewer policyholder deaths), higher-than-expected investment returns on collected premiums, and more efficient operations with lower-than-expected expenses.
Participating policies are specifically designed to be eligible for these dividends, distinguishing them from “non-participating” policies that do not share in the company’s surplus. Mutual insurance companies, owned by their policyholders, commonly issue participating policies and distribute dividends as a return of excess premiums.
How Dividends Are Utilized
Policyholders have several common options for utilizing the dividends received from their whole life insurance policies. Each option offers distinct financial implications and benefits.
One option is to receive the dividend as a direct cash payment. This provides immediate liquidity, allowing the policyholder to use the funds for any purpose.
Alternatively, dividends can be applied to reduce future premium payments. This effectively lowers the out-of-pocket cost of maintaining the policy, as the dividend offsets a portion or all of the premium due.
Policyholders can also choose to leave dividends with the insurer to accumulate at interest. These funds are placed into an interest-bearing account, earning interest at a rate set by the insurer. Accumulated funds can be withdrawn at the policyholder’s discretion.
Another option is to use dividends to purchase Paid-Up Additions (PUAs). PUAs are small, single-premium whole life policies attached to the main policy. These additions immediately increase the policy’s death benefit and cash value, and they also earn their own dividends, leading to a compounding effect. This method can significantly accelerate cash value growth and the overall death benefit without requiring additional medical underwriting.
Taxation of Whole Life Insurance Dividends
The tax treatment of whole life insurance dividends is generally favorable, as they are typically not considered taxable income up to a certain point. For tax purposes, dividends are largely viewed as a return of premium, meaning they are a refund of an overpayment rather than a taxable profit.
Dividends are generally tax-free until the cumulative amount received exceeds the total premiums paid into the policy. If dividends received in cash or used to reduce premiums surpass the aggregate premiums paid, any excess amount becomes taxable as ordinary income.
When dividends are used to purchase Paid-Up Additions (PUAs), the growth within these additions is generally tax-deferred, similar to the cash value of the base policy. The death benefit from PUAs is also typically tax-free to beneficiaries. However, if dividends are left to accumulate at interest, the interest earned is considered taxable income in the year it is credited. The insurance company will typically issue a Form 1099-INT for this interest.
Factors Influencing Dividend Payouts
Whole life insurance dividends are not guaranteed and can fluctuate from year to year, depending on various factors that affect the insurance company’s financial performance. These factors determine the size and declaration of dividends.
The insurer’s investment performance is a key determinant. Returns generated from invested premiums contribute to the divisible surplus. Strong investment returns can lead to higher dividends, while weaker performance may result in lower payouts.
Mortality experience also plays a role. If the actual number of policyholder deaths is lower than the actuarial assumptions, the company pays out fewer death benefits, creating a surplus that can be returned to policyholders as dividends. Conversely, higher-than-expected claims can reduce the available surplus.
Operating expenses are another factor influencing dividend payouts. An insurance company that manages its operational costs efficiently can retain more of its earnings, contributing to a larger divisible surplus. Conversely, increased expenses can reduce the amount available for dividends.
The company’s overall financial health and new policy sales also affect its ability to declare dividends. A robust financial position and consistent business growth enable an insurer to maintain or increase dividend payouts. While dividends are not guaranteed, many established mutual insurance companies have a long track record of consistently paying them due to prudent management.