Life insurance dividends can put extra cash in your pocket, lower your premiums or beef up your coverage. However, not all life insurance companies pay dividends, and those that do can calculate them differently and offer different ways to use them.
What are life insurance dividends?
A life insurance dividend is a return on your life insurance premiums. It’s generally based on how your insurer performs for the year. If the company does well financially — meaning it had successful returns on its investments, paid out less in claims and had lower operational costs than expected — then it may return some of the overpaid premiums to you in the form of dividends.
These payouts are not guaranteed. The insurance company’s board of directors decides annually if and how it will distribute dividends.
How does life insurance dividends work?
“Life insurance dividends are not extra profit but instead represent an overpayment by the policyholders,” said Aaron O’Neal, a certified Chartered Financial Consultant (ChFC) based in Oregon.
Dividends are usually based on three things:
- The investment return the insurer earns on your premiums
- How many death claims were processed that year
- What its annual operating expenses were
If the company has a “good” year in which it underestimated returns and overestimated claims and expenses, it may return some of that surplus back to you in the form of a dividend.
Over time, dividends can offset some of the costs of coverage. If you receive one, you can take it as cash, use it to reduce premiums, increase your death benefit or leave it to accumulate interest within your policy. This provides an extra source of value you can use during your life or pass to beneficiaries.
But remember, there’s no guarantee that you’ll receive a life insurance dividend. So while they can provide a nice potential bonus at times, dividends shouldn’t drive your purchase.
What types of life insurance pay dividends?
You need a participating whole life insurance policy to earn dividends. The word “participating” is key here. If you have a “non-participating” policy, you won’t earn dividends. Here’s why:
Participating whole life policies allow you to share in the insurance company’s profits. The insurer takes its earnings and returns a portion back to eligible policyholders as dividends. These policies may have higher costs to help fund the dividend payouts.
You’ll generally find participating whole life insurance through mutual insurance companies. With a mutual insurer, the company is owned by its policyholders (similar to how a credit union is owned by its members). Since you partially own the company as a policyholder, you may share in any profits through annual dividends and can vote for the board of directors.
If you want dividend potential, opt for a participating whole life policy from a reputable mutual insurance company. This gives you the security of lifetime coverage plus the added perk of earning potential dividends over time. In our study of the best whole life insurance, MassMutual and Northwestern Mutual offer participating life insurance dividends.
How to use life insurance dividends
When you receive a life insurance dividend, you typically have four options:
Take the dividend as a cash payout
Taking the dividends as cash “can be a great idea for high-net-worth clients since these dividends are considered ‘overpayment of premium’ and thus not subject to taxes,” said O’Neal. This gives you money to use any way you want, like investing for retirement or paying off debts.
Apply the dividend toward your policy premiums
As O’Neal puts it: “Why not let the insurance company pay part of your premiums?” This lowers your out-of-pocket cost of life insurance. But it doesn’t provide accessible cash like the first option.
Use your dividend to purchase additional insurance coverage
“You can use the dividends to buy more insurance,” said O’Neal. This increases your death benefit payout to beneficiaries. The additional coverage you purchase is called paid-up additions (PUAs). PUAs won’t increase your annual or monthly premiums because they’re paid in full, and they can also earn dividends and build cash value.
Add the dividends to your cash value
With this option, you have the dividends added to your cash value account where they have the potential to accrue interest, usually tax-deferred. The downside is that you can only access the money if you take a loan or partially surrender.
How are life insurance dividends calculated?
Generally, dividends from life insurance are calculated based on three main sources:
- Lower-than-expected claims payouts
- Lower-than-expected operating expenses
- Greater-than-expected investment returns
“Each year the insurance company sets its rate and expenses based on projections,” said O’Neal. “[It] typical plan[s] for a worst-case scenario, so most years when the final costs and profits for the insurance company come in, [it has] underestimated client premiums and refunds[s] the difference.”
Are life insurance dividends taxable?
Life insurance dividends are not generally subject to tax. “The incredible part of dividends is that, unlike stock dividends, the IRS does not view this as qualified income,” said O’Neal. “Instead these dividends are declared by the insurance companies as ‘overpayment’ and thus are considered a refund of premium and not cash.”
Can you withdraw dividends from life insurance?
Yes, you can withdraw your life insurance dividends, usually tax-free. Most policies let you take dividends as cash payments or leave them in your cash value account to accumulate interest you can later withdraw.
Withdrawing dividends doesn’t typically impact your death benefit. As long as premiums keep getting paid, your beneficiaries still get the full payout when you pass away. However, if you take a loan from your cash value and pass away before it’s paid off, the outstanding balance will likely be deducted from your death benefit.
Additionally, any withdrawals that exceed what you’ve paid in premiums get taxed as ordinary income. Work with your insurer or a tax professional if you have questions about dividend withdrawals.
Frequently asked questions (FAQs)
Choosing a life insurance policy with dividends gives you potential cash payouts, lower premiums and increased coverage. In other words, you can use the dividends to optimize your policy to better suit your needs.
No, life insurance dividends aren’t guaranteed. Because they’re based on the insurer’s annual financial performance, dividends are “nonguaranteed” by default.
That said, there are “guaranteed” parts of a life insurance policy, such as the death benefit and cash value, assuming you pay your premiums, your investments perform well and you meet all conditions of your policy.
You’ll typically receive life insurance dividends annually. But remember, life insurance dividends aren’t guaranteed. The insurer may reduce or skip dividends during low-profit years.
Yes, most insurers let you reinvest dividends by adding them to your cash value account. But depending on your financial situation, it may make more sense to take that money as cash and reinvest it in the stock market instead for a potentially better return.
Or, if you use your dividends to buy paid-up additional life insurance instead, this coverage will also grow cash value and has the potential for more dividends, all while providing a larger death benefit and not increasing your premium payments.
All participating life insurance policies are eligible to earn dividends. But that doesn’t mean your insurer will pay them out every year. Evaluate a company’s past track record for paying out dividends to estimate how likely it is to pay them in the future.
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