Life insurance dividends, also known as a return of excess premium, are paid out to participating life policies when insurance companies earn excess profits after claims and operating costs are covered. Participating life insurance policies are usually whole life policies that pay dividends, but permanent coverage can be participating or non-participating.
Dividends are determined differently for privately held (stock) and mutual companies, and policyholders have a number of options on how to use their life insurance dividends. Finally, dividend amounts change each year and are not guaranteed, but dividend paying whole life insurance policies charge higher premiums.
Life Insurance Dividends & Payouts
Your dividend is paid out on the annual policy anniversary (the date it was purchased) the year after which the dividend is earned. Participating policy dividends can be paid out in 4 main ways, and you have the choice to pick which method makes the most sense for you.
- Cash – the insurance company sends you a check for the dividend amount.
- Premium Payments – your dividend can cover and pay up your premium payments.
- Savings – dividends may be deposited in your policy’s cash value and allowed to earn interest.
- Buy More Insurance – dividends may be used to buy paid up coverage.
Since your dividend is usually calculated as a percentage of your current cash value, it is important to note that outstanding loans and withdrawals using your cash value as collateral will reduce payments. For example, if your current cash value is $50,000 and the dividend yield is 3.5%, your payout will 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.
Note: if you consistently re-invest your dividends into the cash value, your distributions will grow year-over-year. The growth of your returns can be considerable after 10, 15 or 20 years.
Private vs. Mutual Life Insurance Companies
Mutual life insurance companies are owned by their policyholders. Insurance 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.
If life insurance dividends are used to pre-pay premiums, added to the cash value or used to buy paid up additions to your whole life insurance policy, dividends are not subject to income tax because distributions are not made directly to you.
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 over-payment of premiums through the year.
In the event that the dividend exceeds the yearly premium, the amount in excess of the premium is taxable as income 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.
Participating Life Insurance in Financial Planning
If dividend-paying whole life insurance is a part of your financial plan, you should thoroughly research and find the best life insurance company that fits your needs. The company should be financially-stable (minimum “A” rating) with a history of paying dividends regularly. Since interest earned on your cash value is tax deferred until it is withdrawn, a participating policy can have significant tax advantages for some families.
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 before deciding if life insurance dividends are essential to your financial plan.