What Are Insurance Dividends & How Do They Work?

Insurance dividends offer a financial benefit to policyholders, representing a share in an insurance company’s financial success. These distributions are distinct from stock dividends, as they reflect a return of premium rather than an investment gain. Understanding how these dividends are generated, received, and taxed helps policyholders maximize their insurance coverage value.

Understanding Insurance Dividends

An insurance dividend is a payment made by an insurance company to its policyholders, returning a portion of the premium paid. These dividends are not guaranteed and depend on the insurer’s financial performance, including favorable investment returns, lower-than-expected claims, and efficient expense management. The funds for dividends come from the company’s “distributable surplus.”

A distinction exists between mutual and stock insurance companies regarding dividends. Mutual insurance companies are owned by their policyholders; any profits or surplus generated are shared with these policyholders as dividends. In contrast, stock insurance companies are owned by shareholders, and their profits are distributed to shareholders, not to policyholders.

Dividends from mutual companies are not considered investment gains, but a refund of overpaid premiums. This structure allows policyholders to participate in the company’s success. Policies that offer dividends are known as “participating” policies, with whole life insurance being a common example.

Receiving Your Insurance Dividends

Policyholders have several options for receiving or utilizing their insurance dividends, offering flexibility to meet financial needs. These choices are made when the policy is issued but can be changed later. Each option offers a distinct advantage depending on the policyholder’s goals.

One option is to receive the dividend as a direct cash payment, where the insurer sends a check or transfers funds to the policyholder. Another choice is to apply the dividend to reduce the next premium payment, lowering the out-of-pocket cost for coverage. This can help manage ongoing expenses associated with the policy.

Dividends can also be used to purchase Paid-Up Additions (PUAs), which are small, fully paid-for increments of additional life insurance coverage. PUAs immediately increase the policy’s death benefit and cash value, and they earn their own dividends, leading to a compounding effect. This option enhances the long-term growth and value of the policy. Policyholders may also use dividends to repay an outstanding policy loan or its accrued interest. This reduces policy debt and restores the policy’s full cash value.

Tax Implications of Insurance Dividends

Insurance dividends receive favorable tax treatment, as they are not considered taxable income. The Internal Revenue Service (IRS) views these dividends as a return of premium, meaning they are a refund of an overpayment rather than a taxable gain. Therefore, dividends are not taxed until the cumulative amount received exceeds the total premiums paid into the policy.

If the total dividends received exceed the total premiums paid, the excess amount becomes taxable as ordinary income. For example, if $10,000 in premiums have been paid and $10,250 in dividends are received, the $250 excess would be taxable. Interest earned on dividends left with the insurer to accumulate may also be taxable.

Policyholders should also be aware of Modified Endowment Contracts (MECs). If a life insurance policy is overfunded beyond certain IRS limits, it can be reclassified as an MEC, altering the tax treatment of withdrawals and loans. For MECs, dividends and other distributions are taxed on a “last-in, first-out” (LIFO) basis. This means earnings are considered withdrawn first and are subject to taxation, potentially including a 10% penalty if the policyholder is under age 59½. In some taxable scenarios, a Form 1099-R may be issued to report distributions from insurance contracts.