Whole life insurance is the only type of life insurance that pays policyholders an annual dividend. Other forms of life insurance including term life, variable universal life, and traditional universal life insurance do not pay dividends.
What Is a Life Insurance Dividend?
A life insurance dividend is a cash payment made by the life insurance company to the owners of whole life insurance policies. Dividends are made on the policy anniversary date every year. While not guaranteed to be paid every year by the life insurance contract, most major life insurance companies have made dividend payments every for over a hundred consecutive years. Dividend payments are made to owners of whole life policies as a way for the owners to share in the profitability of the company. Traditionally, this is because life insurance companies were organized as mutual companies. In a mutual company, the policy owners are actually the owners of the company. Dividend payments are meant to distribute profits to the owners. Nowadays, life insurance companies are not always organized as mutual companies, but even if the company is organized a different way the company still needs to pay dividends on whole life policies in order to be competitive with mutual companies.
Whole life insurance will pay dividends as long as it is a “participating” policy. This term means the owners of whole life participate in the financial gains of the company. Not every whole life insurance policy is participating, however, the majority of policies are. A nonparticipating policy may be less expensive on an annual basis, but it will not enjoy the same type of long term value in terms of return on investment. You should always purchase a participating whole life policy since it is financially favorable over the long term.
Tax Treatment of Dividend Payments
For tax purposes, dividends are treated as a return of premiums already paid. Because they are viewed as a return of premium, they are not taxable until more dividends are paid back to the owner than they paid into the policy in total premium payments over the lifetime of the policy. Dividends reduce the cost basis of the policy because they are viewed as a return of premium. Once all of the premiums are returned, dividends are taxable as income. If the policy is a modified endowment contract, taxation is a bit more complex.
How Can Dividends Be Used?
Dividends can be used in a few different ways. The owner has a choice about how to use dividends, which balance cashflow and death benefit growth. The options for dividends are:
- Take it as a cash payment. This will pay you more money in the immediate term, but possibly less over the long term than other options.
- Use it to purchase additional paid-up insurance. This will increase future dividends because it increases the policy size, and it increases the cash surrender value. This is a great way to compound the growth rate of the policy and grow the death benefit.
- Use it to offset premium due. This reduces the amount of premium by the amount of the dividend. Any excess over the total premium due can be used for other purposes.
- Use it to accumulate interest in cash. You can store the dividend value in cash and get paid interest. This can increase the cash value over time with compounding interest and savings.
Dividends are not Guaranteed
Even though dividends have consistently been paid, they are not contractually guaranteed. In fact, when a whole life insurance policy is illustrated, usually at least two values are shown. The first is the guaranteed minimum value, which shows how the cash value will grow if all premiums are paid, no loans are taken, and no dividends are paid. The second will be the value of the policy with estimated dividend payments, which are estimated at the current dividend rate being paid by the company. The dividend value can then be illustrated with the dividend being used to purchase additional paid-up life insurance, used to pay premiums, or paid directly to the owner as income.
Why Don’t Other Life Insurance Types Pay Dividends?
It may seem like whole life insurance owners are unfairly incentivized to buy whole life, vs other types of life insurance. There are a few reasons why other types of life insurance do not pay dividends though, and they are good reasons.
- Term life insurance competes on price. It is pretty much a commoditized product, and clients usually choose the lowest priced option. Life insurance companies would have to raise premiums on term life policies in order to pay dividends, and it wouldn’t make sense to do this.
- Term life insurance is not permanent. Whole life insurance owners get to participate in the perks of ownership because they are truly buying into their policy for a lifetime.
- Tradition is a factor. Whole life insurance is the original form of life insurance. Mutual companies were organized based upon the sale of whole life products.
- Universal life pays interest instead of dividends. Universal life insurance pays owners on their cash value in a different way. Interest accrues on the cash value and is paid into the policy.
- Variable life insurance cash is invested in subaccounts that invest in capital markets. These are like mutual funds and growth happens if these investments perform well. The cash that whole life insurance owners hold in their policy is used by the life insurance company for their own investments. In a universal and variable universal policy, the life insurance company does not benefit the same why by investing cash value on their own behalf, like they do with whole life.
The type of policy an owner ultimately chooses (participating or nonparticipating) depends in part upon the ultimate use of the policy. If you as a prospective owner see the possibility that the cash value will be accessed as income or loans, or if you can afford to pay slightly higher premiums in the beginning years of the policy for the advantage of having the policy “paid up” or self-sustaining with dividends at some point in the future a participating dividend-paying policy will be most advantageous. If you prefer lower premiums and only foresee the need for the policy to continue for the whole life of the insured for the lowest annual amount, a nonparticipating policy may be for you. To read about whole life insurance as an investment, read our article here.
It is wise to compare the cash value accumulation outcomes of both participating and nonparticipating policies when you are considering the purchase of a whole life insurance policy. By seeing the actual illustration it can give more perspective on how the dividend will help pay for the policy and provide income, or how much less the premium payments may be on a non-dividend-paying policy. To illustrate both participating and nonparticipating policies please enter your zip code in our quote comparison tool and you can view quotes for both forms of policies.