A life insurance dividend is a non-guaranteed payment from the insurance company to the policy owner representing profits the company earned during the policy year. Insurance companies often view dividends as a sharing of the surplus created by their insurance activities among policyholders whose insurance contracts generate profits beyond the insurer's expectations.
A dividend also technically represents a refund of premiums paid by the policyholder for his/her insurance. In essence, the tax law governing insurance allows the insurer to give back premiums paid by a policyholder because it turns out the insurer didn't need all the premiums paid to provide the insurance protection under the contract. This refund of premium also has a few tax implications, which we will discuss a little later in this article.
Not all life insurance policies can earn the policyholder a dividend. The insurance contract must be a participating policy in order to provide the opportunity to earn dividends. If the policy is participating and the insurance company does choose to pay a dividend to policyholders, then the policyholder might earn a dividend depending on the profitability of his/her type of insurance policy.
What Do you Do with Life Insurance Dividends?
The options you have regarding your dividends earned on a life insurance policy will depend on the type of life insurance policy you own. Whole life insurance policies will have the greatest number of options. In fact, whole life insurance is the most common type of life insurance to earn dividends.
While it's far less common, term life and universal life insurance policies can also earn dividends.
Two dividend options universally available to all types of life insurance policies are Paid in Cash and Reduce/Pay Premiums.
If choosing the dividend option as a cash payment, the insurance company will simply send you a check when it pays its dividend to policyholders. You are then free to do whatever you wish with the money.
The option to reduce/pay the premium with the dividend will either partially offset or completely take care of the premium due on your life insurance policy. If the dividend is less than the premium due on your policy, this option will reduce the premium you pay. Once the company applies the dividend to your premium, you'll be responsible for the remainder. If the dividend is large enough to cover the entire premium, you'll pay nothing out-of-pocket for your life insurance. This situation can continue provided the dividend paid by the insurance company does not go down. If the dividend is larger than your premium due, you can choose a different dividend option for the remaining amount. It is very common for the insurance company to require you to pay your premium annually if choosing this dividend option.
Other dividend options exclusive to whole life insurance are: Purchase Paid-up Additions, Accumulate at Interest, and Purchase Additional Term Life Insurance
The option to purchase paid-up additions is often a default dividend option for whole life insurance policies. This option uses your dividend to purchase additional immediately paid-up whole life policies that are attached to your original whole life policy. These additions can earn dividends themselves, and this acts as a way to compound whole life cash value and death benefit.
The accumulate at interest option places the dividend in an interest-paying account that will act as a sort of savings account. The insurance company will pay regular interest on the cash in the account. You are free to take the money out of the account whenever you want, but you cannot put additional money into the account–only dividend payments can go into the account. It's important to understand that this savings-like account is outside of your whole life policy, which means it does not benefit from the tax-favorable features whole life cash value. It's also important to understand that these accounts do not generally have depositors' insurance (i.e. FDIC or NCUA coverage).
The option to purchase additional death benefit coverage through term life insurance uses the dividend to buy term life insurance on the insured of the policy. This feature can provide a higher death benefit amount than whole life can provide with the same premium amount.
How Often are Life Insurance Dividends Paid?
Generally speaking, life insurers pay policyholders dividends once per year at the policy anniversary date. However, in less common situations, an insurer might pay a terminal dividend either when an insured dies or a policy owner cancels a policy. In this situation, it's possible to receive two different dividend payments. Once for the regular dividend and then again for the terminal dividend.
How are Dividends Calculated?
The specific calculation for a dividend is complex and often a closely guarded trade secret among life insurers. However, there are major components that all insurers use that capture the intent of a dividend paid to a life insurance policyholder.
The three major components of a life insurance dividend come from the insurers:
- Underwriting Profits
- Investment Profits
- Budgeting Profits
Underwriting profits come from the act of being an insurance company. It is essentially a profit created when an insurer pays out fewer claims than anticipated. The insurer now has more money on hand from the collection of premiums than it thought it needed to cover all claims paid out.
Investment profits take place when the insurer generates returns on the assets it purchases to support the guarantees it makes under its life insurance contracts that exceed the guaranteed features of those contracts. So if an insurer needs a return of 4% to cover policyholder obligations, but it generates 5% on its invested assets, the insurer now has a profit in the returns it achieved in excess of those needed to provide policy guaranteed benefits.
Budgeting profits come about when the insurer operates under budget. This could look something like the insurer budgeting a certain amount for the labor needed to conduct business, but finding out at the end of the year that is only spent 90% of the money budgeted for this purpose. It's rare for this component to add much to the overall payment of dividends as budgets tend to be very accurate.
Can you Withdraw Dividends from Life Insurance?
If you own whole life insurance and you use your dividends to purchase paid-up additions, you can decide to withdraw those paid-up additions from the policy. This is sometimes referred to by insurance companies as surrendering/withdrawing dividend additions.
You not technically withdrawing the dividend per se, because you used the dividend to purchase paid-up additions. But the money from the paid-up additions exists because of the dividend so you could think of it as storing the dividend in your policy through this feature and then withdrawing the dividend at a later date.
Doing this could mean that you end up with more money than the amount of the original dividend. This happens because the paid-up additions will earn guaranteed contract interest as well as dividends if payable.
Do you Have to Pay Taxes on Dividends from Life Insurance?
The taxability of life insurance dividends is more a question of when not if. I don't mean to say that all life insurance dividends will eventually become taxable. Instead, I mean there are circumstances when dividends are taxable and when they are not taxable. The vast majority of the time they are not taxable.
But you should know that because dividends are a refund of premium they do reduce the cost basis in your policy if you take them out of the policy. This could eventually mean that you will pay taxes on future dividends and/or that withdrawing cash from your policy will be taxable if withdrawn.
Are Dividends Guaranteed?
Life insurance dividends are not guaranteed. They are paid at the discretion of the life insurance company and life insurers make no guarantee regarding dividends. They can and do change. This means the dividend amount received this year might be more or less than the dividend payment received next year. There is no promise from the insurance company regarding and a specific amount of dividends paid or that it will pay any dividend in any given policy year.
But it's also worth understanding that most insurance companies currently paying dividends to policyholders have made these payments for many years (some well more than 100 consecutive years). These companies take the payment of dividends very seriously and there are insurance laws that mandate the payment of dividends when profits exist for participating-types of life insurance.
I get dividends are a refund of premiums but they are also the performance of the companies investments and sale of other products am I correct? If so then why wouldn’t those other parts of the dividend be taxed?
Because tax law says so.