Dividends and Participating Policy Contracts
In its simplest form, a dividend is money from your life insurance company to you. Often this means that you have a whole life insurance policy that pays dividends, also referred to as a participating policy contract. When it comes to dividends, purchasing a participating policy contract with a company is like investing in that company. When that company is profitable, it rewards your investment by paying you dividends. It’s important to note that this is only available for participating life insurance policies.
Similar to an investment, dividends are not a set price. As the company does well or poorly, the amount you receive from your dividend varies. Companies cannot guarantee a dividend in advance, but once a dividend has been paid it cannot be taken away. Dividends can be different with each company. So, be careful to do your research on the company’s dividend-paying history. Some dividends are dependent on your policy loan status, meaning with an outstanding loan, you could earn less dividends. How dividends are paid is determined by Direct and Non-Direct Recognition policy status.
To have a policy with dividends included, you are often paying a higher premium. Because of this, the tax world considers that dividends are the insurance company paying you back for a high premium. Therefore, if you are receiving dividends through a participating whole life policy, most options are not taxed. This is so exciting and important to us, we’ve written a whole article about it.
Life insurance dividend Options are the different ways you can elect to receive your dividend. All of the following are common dividend options except the fifth. Applying your dividend toward paying for term insurance is becoming more popular, but isn’t one of the classic dividend options.
Let’s get into how each option works, as well as their pros and cons.
Receiving Your Dividend as a Cash Payment
This option is exactly what it sounds like. Yearly, your insurance company will write you a check for the dividend. Then, you can use the cash however you’d like. Like we mentioned earlier, dividends are seen as a premium refund. When receiving it as cash, it isn’t taxed.
This tax policy is applicable until you meet the cost basis of your policy. For instance, let’s say you paid a whole life insurance policy for 15 years and your cost basis is $70,000. Then, you opt for dividends in the form of a cash payment. The day you receive a total of $70,000 in cash dividends, your future cash dividends become taxable income. Also, once dividends meet the cost basis (the process described above), anything withdrawn from the policy is also taxable.
Putting Your Dividend Toward Paid-up Additions (PUAs)
PUAs are smaller, micro-policies that augment your original policy, increasing the cash value significantly. When you choose this option, you opt for your insurance company to use your dividend money to pay for paid-up additions. We recommend our clients elect purchase paid-up additions as their option because it allows their dividend to create the most long-term value.
Here’s how. With the PUA dividend option, your insurance company will use the dividend to purchase the PUA at your policy’s issue age. Since insurance gets more expensive the older you get, this is really key to this option. By purchasing the PUAs through your younger age, you’ll have more cash value increase than the amount of the dividend actually declared. This option also sets you up to receive more dividends in the future. Dividend eligibility is based on the amount of your death benefit (also called paid-up insurance). And as you acquire more PUAs, both your cash value and your death benefit increase. As your death benefit increases, you become eligible for more dividends.For all of these reasons, we recommend this option.
Putting Your Dividend Toward Your Premium
This life insurance dividend option is fairly straightforward. When chosen, your insurance company will simply use your dividend to pay some or all of your yearly premium. Choosing this option involves choosing a secondary option if your dividend is even larger than your premium. On the other hand, if your dividend is less than your premium, you’ll need to pay the rest as you normally do.
When you opt for using your dividend toward your premium payment, you must start paying your premium annually. For instance, if your annual premium is $8,000 and your dividend that year is $1,500, you would still need to pay the remaining $6,500 all at once. Since dividends fluctuate, you might be paying more or less of your premium each year.
Leaving Your Dividend in an Account to Accrue Interest
This option creates an account for your dividends that includes interest, and the interest rate can change yearly. The account is exclusive to dividend payments. Unfortunately, you cannot choose to add other funds when you notice that the interest rate is good or for any other reason.
Also, this account does not benefit from the other tax-exempt dividend options.
Use Your Dividend to Purchase Term Insurance
Finally, this life insurance dividend option has emerged rather recently allowing you to pay for term insurance with your dividends. This option is the most efficient (short term) for a significant death benefit. If your dividend exceeds the cost of the term insurance, you’ll need to choose a secondary option as well.
After all this talk about life insurance dividend options, you might want to understand even more about them. This video explores if dividends are all they’re cracked up to be, and you can always schedule a complimentary strategy session to see a life insurance illustration with illustrated dividends.