What Are Life Insurance Dividends and How Do They Work?
Explore the inner workings of life insurance dividends. Understand their origins, diverse applications, and crucial tax considerations for informed policy management.
Beyond its primary function, certain life insurance policies can provide an additional feature: dividends. These distributions offer policyholders various ways to benefit from the insurer’s financial performance.
Understanding Life Insurance Dividends
Life insurance dividends represent a portion of an insurance company’s surplus distributed to policyholders. These are typically paid by mutual insurance companies, which are owned by their policyholders, on participating whole life insurance policies. Dividends are not guaranteed payments; instead, they are a distribution of the company’s financial surplus, reflecting performance that exceeded initial projections.
Dividends are a return of a portion of the premium that was in excess of the actual cost of providing coverage. When a policy is issued, the premium is set based on conservative assumptions regarding mortality rates, operating expenses, and investment returns. If the company’s actual experience is more favorable than these assumptions, a surplus may be generated, from which dividends can be paid. This means that while premiums are fixed, dividends can effectively reduce the net cost of the policy over time.
How Dividends Are Generated
Life insurance companies generate the surplus that allows them to pay dividends through three primary sources. First, favorable mortality experience contributes to this surplus when fewer policyholders die than projected, meaning the company pays out less in death benefits.
Second, lower-than-expected operating expenses can create a surplus. If the company manages its administrative and operational costs more efficiently than assumed, the savings contribute to the divisible surplus.
Third, higher-than-expected investment returns on the company’s assets play a significant role. Insurance companies invest premiums to generate income, and if these investments perform better than the conservative rates assumed when setting premiums, the additional earnings contribute to the surplus available for dividends. These three factors collectively lead to the “excess premium” that the company returns to policyholders as a dividend.
Options for Using Dividends
Policyholders have several choices for how to receive or apply their life insurance dividends, offering flexibility to meet various financial goals. One straightforward option is to receive the dividend directly as a cash payment, providing immediate access to funds.
Another common choice is to apply the dividend to reduce future premium payments. This can effectively lower the out-of-pocket cost of maintaining the policy, and for older policies with substantial dividends, it may even cover the entire annual premium.
A popular strategy for compounding growth is to use dividends to purchase Paid-Up Additions (PUAs). PUAs are small, single-premium, paid-up insurance policies that immediately increase the policy’s cash value and death benefit without requiring additional underwriting. As the policy’s cash value and death benefit grow, this can lead to larger future dividends, creating a powerful compounding effect.
Policyholders can also choose to leave the dividends on deposit with the insurance company. When dividends are left on deposit, they accumulate interest at a rate specified by the insurer. These funds remain liquid and can typically be withdrawn at any time without reducing the policy’s cash value or death benefit.
Finally, dividends can be used to repay policy loans. If a policyholder has borrowed against the cash value of their life insurance, applying dividends to the loan balance can help pay down or pay off the outstanding debt, including accrued loan interest.
Tax Implications of Dividends
The tax treatment of life insurance dividends is generally favorable for policyholders. Life insurance dividends are typically considered a return of premium, not taxable income. The Internal Revenue Service (IRS) views these distributions as a refund of an overpayment, rather than a taxable gain.
Dividends generally become taxable only if the cumulative dividends received exceed the total premiums paid into the policy. For example, if a policyholder pays $10,000 in premiums over several years and receives $10,500 in dividends, only the excess $500 would be considered taxable income.
While the dividend itself may be non-taxable up to the premium basis, any interest earned on dividends left on deposit with the insurer is considered taxable income. This interest must be reported for tax purposes in the year it is credited or received. Similarly, if a policy is classified as a Modified Endowment Contract (MEC) due to exceeding certain premium limits, dividends, loans, and withdrawals may be taxed differently, potentially as ordinary income.