Whole life insurance policies normally pay dividends. For mutual companies, the dividend represents a partial return of company profits to the owners of the company, the policy owners. For companies with different organizational structures the dividend is necessary to stay competitive with whole life offerings from mutual companies. It is rare to see a whole life insurance illustration without expected dividend payments shown.
While the contract typically states that dividends are not guaranteed, most of the large national life insurance companies boast records of paying dividends for over a hundred years. This spans the great depression and other financial crisis’s and recessions, so dividend payments can be counted on. Usually dividend payments become a substantial dollar amount as the policy ages. Conveniently, the life insurance company offers different options for ways to use the dividend payment. If you want to compare the effect of the different options, request that they each be illustrated so that you can compare them. Here we discuss the dividend payment and what choice might be best for you.
Option 1 – Offset Premium Payments
Many people choose the simplest and most convenient option with their dividend payment, to offset the premium due on the policy. As an example: If the premium due on the policy is $500 and the dividend payment is $200, the policy owner can use the $200 to reduce the premium owed to the insurance company to $300 ($500 minus $200). This option is as simple as it sounds, as long as the dividend is lower than the premium due. Believe it or not, most of the time the dividend eventually grows larger than the premium owed. When this happens, you must also choose what to do with the excess premium.
Why You Would Choose to Offset Premiums
You might choose to use your dividend payment to offset premiums because it lowers your bills. You keep the same insurance coverage, grow your cash value at the same rate as you would otherwise, but pay the insurance company less money. There is no tax effect to choosing this option, there is no change to your death benefit, and you can expect to owe the insurance company progressively less as your dividend payment grows. This can be an option if you lose a job or your income drops, and you want to lower your regular bills. This way you can make your policy less expensive to keep, without surrendering your coverage.
Option 2- Take as Cash
If you want to receive the dividend payment as a cash payout, you can do this as well. Taking the payment as cash is considered a return of premium. For tax purposes, a life insurance policy is not taxable until the amount surrendered or taken out as dividends exceeds the amount of premiums paid into the policy. To be clear, this has nothing to do with the death benefit being taxable, only to the tax treatment of money taken from the policy while the insured person is alive. Dividends from a life insurance policy can be a great tax free source of income. Normally the dividend rate grows over time, so the amount paid out will grow year over year. Prevailing interest rates and company claim history and profitability can affect dividend payouts, so they do not always rise every year.
Why You Would Choose to Take A Dividend as Cash
You would choose to take the dividend payment as cash if you want the income stream it provides. It may be unnecessary to take the dividend as cash if it does not exceed the premium payment, because you are swapping payments with the life insurance company, but sometimes this still makes sense. For instance, if a policy has a different owner than payor, the owner may take the dividend as an income stream and the payor has agreed to cover the premiums. Far more often, someone will offset premium payments with the dividend until the dividend becomes greater than the premium, and then take the excess as cash.
Eventually, taking the dividend as cash can create a substantial and regular source of income. You should choose this option if you want the income from your policy. Considering the special tax treatment of life insurance policies (FIFO accounting), this can generate a tax free income source for years without reducing your insurance coverage.
Related Option- Keep in Interest Bearing Account with Life Insurance Company
Your life insurance company may also allow you to keep the dividend payment in a cash account separate from your policy cash value. They will typically pay a small rate of interest on this account and the money gets paid out upon surrender of policy or death. For tax purposes, it is the same as taking the money as cash. We don’t typically recommend choosing this option because there are typically higher rate interest accounts available outside of the insurance company. It can be something to keep in mind if the rate offered is high enough.
Option 3- Buy More Paid Up Insurance
Most companies allow you to use the dividend payment to purchase additional life insurance without any additional underwriting. This is “paid up” insurance, so it does not increase your premium payments even though the coverage increases. Not only does the additional insurance provide more coverage, but it also increases the future dividend payments (all else being equal). In this way it can compound your dividend payment increases and create a bigger and bigger policy with the ability to generate more and more cash value and cash dividends. In turn, the larger dividend payments are able to purchase even more paid up whole life, which increases future dividend payments and cash value growth even more. It takes time for this to really compound into significant increases, but over the course of years and even decades it can dramatically increase the size of the policy.
Why Purchase more Paid up Insurance
You would do this to grow the size of your policy. Choosing this option year over year creates a compounding effect increasing the death benefit, cash value account, and dividend payment at increasing rates. If you don’t need to offset your premium payment or take the money as cash, it can be a great way to set your policy up to grow over time. The additional coverage can be especially valuable if you lose your insurability, meaning you can no longer be issued more life insurance coverage because of your health. This may become your best or only option for increasing your coverage.
Which Option is the Best?
There is not necessarily a best option for everyone, it all depends on your objectives. If you are simply looking to maximize your financial returns, you should look at the effect of each option with a life insurance illustration. In the short term, offsetting premium payments and taking any remainder as cash typically provides the highest rate of return. In the longer term, purchasing more paid up insurance typically results in significant enough compound growth to outpace offsetting premiums. If you want to compare offsetting premiums and saving the difference in an investment account, you may end with a different result depending on the rate of return assumptions used. If you take into account the death benefit as a part of the rate of return (not necessarily recommended but possible), you may be best served to purchase paid up insurance.
You may change your option over the course of the policy lifetime. Insurance companies allow unlimited changes. If your income drops, maybe you are more concerned with taking the money out as cash rather than buying more insurance. If you lose your insurability, maybe more insurance is a priority. If your dividend grows large enough for a long enough period of time, maybe your dividend payments start to become taxable, and you no longer wish to receive them. The only way to choose the best option for yourself is to account for your personal situation and long term objectives. We encourage you to speak with your financial advisor or life insurance agent if you have any questions regarding which option is best for you. You do need to choose an option, otherwise the insurance company will choose for you, and they always choose to hold onto the money themselves. If you can take any piece of advice with you, it is to request a comparison illustration showing how each option effects your policy, cashflow, and future dividends.