Life Insurance and Dividends: Making the Most of Your Policy

When people hear the word dividends, they often think of stocks, investments, and quarterly payments. But did you know that some life insurance policies can pay dividends, too?

If you own an eligible participating whole life insurance policy, you may have several options for using those dividends. Depending on your goals, you could receive the money directly, use it to reduce your premium, or purchase additional life insurance.

The important thing is understanding what your options mean and how they fit into your overall financial plan.

Let's take a closer look at how life insurance dividends work and what you should consider before deciding what to do with yours.

What Are Life Insurance Dividends?

Life insurance dividends are payments that may be made to owners of certain participating whole life insurance policies.

These dividends generally reflect the insurance company's financial experience, including investment performance, claims, and operating expenses. When the company's experience is more favorable than anticipated, it may have a surplus available to distribute to eligible policyholders.

However, life insurance dividends are not guaranteed. An insurance company's history of paying dividends doesn't guarantee that it will continue paying them at the same level in the future.

It's also important to understand that life insurance dividends aren't the same as stock dividends. They don't represent ownership in a publicly traded company, and the dividend amount isn't a guaranteed investment return.

Not every life insurance policy pays dividends. Term life insurance policies generally don't offer them, and some permanent life insurance policies are nonparticipating and aren't eligible for dividends.

If you have a participating whole life policy, review your policy documents or contact your insurance professional to understand which options are available to you.

Four Ways to Use Life Insurance Dividends

If your policy pays dividends, you may have several choices. The options available depend on your particular policy and insurer, but four common choices are cash payments, premium reductions, paid-up additions, and leaving dividends to accumulate with interest.

1. Receive Your Dividends in Cash

Sometimes, the simplest option is the right one.

Depending on your policy, you may be able to receive your dividends directly rather than applying them to the policy.

You could use the money for everyday expenses, build up your emergency savings, pay down debt, or put it toward another financial goal.

For example, imagine your policy pays a $600 dividend for the year. You might decide that having the extra $600 available for an upcoming expense is more useful than increasing your life insurance coverage.

This option gives you flexibility, but remember that dividends aren't guaranteed to remain at the same level from year to year.

Also, the tax treatment depends on how the dividend is handled and your policy's circumstances. If the insurer pays interest on dividends you leave with the company, that interest is generally taxable income.

2. Use Dividends to Reduce Your Premiums

Another option is applying dividends toward your policy premiums.

This can reduce the amount you need to pay out of pocket to maintain your coverage.

For example, suppose your annual premium is $1,800 and your policy provides a $500 dividend. If the dividend is applied to your premium, you would generally need to cover the remaining $1,300 yourself.

That can make an existing policy more manageable without requiring you to change your coverage simply because your budget has changed.

However, there's an important distinction: a dividend used to reduce premiums isn't a guarantee that your policy will remain affordable indefinitely. Because dividends can change, you should understand how much of your premium is contractually guaranteed and how much depends on future dividends.

If you rely on dividends to cover part of your premium, ask your insurance professional what would happen if future dividends were lower than expected.

3. Purchase Paid-Up Additional Insurance

For some policyholders, using dividends to purchase paid-up additions can be an attractive long-term strategy.

Paid-up additions are small amounts of additional whole life insurance purchased with the dividend. They generally don't require ongoing premiums of their own, and they can increase the policy's death benefit and cash value.

Depending on the policy, paid-up additions may also be eligible to receive future dividends.

Imagine that you already have a whole life policy intended to provide long-term protection for your family. Rather than taking each year's dividend in cash, you choose to purchase additional paid-up coverage.

Over time, those additions can increase the total amount of insurance your beneficiaries may receive and the policy's available cash value.

This option may appeal to people who want to increase their coverage or build additional value within an existing policy.

However, the results depend on the policy's terms, the dividends actually paid, and other factors. Paid-up additions should not be viewed as guaranteed investment growth.

Before choosing this option, ask for an illustration showing how the policy is expected to perform and which values are guaranteed versus non-guaranteed.

4. Leave Dividends With the Insurance Company to Accumulate

Some policies allow dividends to remain with the insurer and earn interest.

This may appeal to policyholders who don't need the money immediately and prefer to keep it available for future use.

However, this option deserves careful consideration. Interest credited to dividends left with the insurance company is generally taxable, even when the original policy dividends would otherwise be treated as a return of premium.

You should also compare the insurer's interest rate and withdrawal terms with other places you could keep your savings.

Leaving dividends with the insurer isn't automatically the best choice simply because the money remains associated with your life insurance policy.

Which Dividend Option Is Right for You?

There isn't one dividend option that's best for everyone.

The right choice depends on what you want your life insurance policy to accomplish and what your broader financial situation looks like.

Here are a few questions worth asking yourself:

• Do you need the money today? Receiving dividends in cash may provide flexibility for current expenses or other priorities.

• Are your premiums becoming difficult to manage? Applying dividends toward premiums may reduce your out-of-pocket costs, although future dividends aren't guaranteed.

• Do you want additional life insurance? Paid-up additions may increase your death benefit and cash value.

• Are you saving for a future goal? Leaving dividends to accumulate may be an option, but compare the interest rate, tax treatment, and available alternatives.

• Has your financial situation changed? A strategy that made sense when you purchased your policy may not be the best fit today.

Your answers can help you determine which option deserves a closer look.

Don't Choose Based on Dividends Alone

It's easy to focus on the dividend when reviewing a participating whole life policy. After all, receiving additional value from an existing policy can be appealing.

But dividends are only one part of the picture.

You should also understand your policy's premiums, death benefit, cash value, guarantees, and long-term costs. If you're comparing policies, look at the overall contract and its projected performance rather than judging it solely by the insurer's current dividend scale.

And if your financial goals have changed, don't assume you need to keep doing the same thing with your dividends year after year.

A conversation with a qualified insurance professional can help you understand the available choices and the tradeoffs involved.

If you're considering surrendering a policy, making withdrawals, or taking a loan against its cash value, get advice before acting. Depending on the circumstances, those decisions can affect your coverage, available cash value, and tax situation.

What About Taxes on Life Insurance Dividends?

Tax treatment is another important consideration.

Life insurance policy dividends are generally treated as a return of premium up to the amount of your investment in the contract. However, interest earned on dividends left with the insurer is generally taxable.

Other transactions involving a policy such as surrendering it, taking certain distributions, or allowing a policy to lapse with an outstanding loan can have different tax consequences.

Because the details matter, it's wise to consult a qualified tax professional if you're unsure how a particular transaction will affect you.

The goal is to understand the full financial impact before making a change.

Make Your Policy Work for Your Goals

Life insurance dividends can give eligible policyholders additional flexibility. You may be able to receive them as cash, use them to reduce premiums, purchase paid-up additions, or leave them to accumulate with interest.

But the best choice isn't necessarily the one that produces the largest projected policy value or the biggest immediate payment.

It's the one that makes sense for your needs, your budget, and the purpose of your coverage.

If you own a participating whole life policy and aren't sure how to handle your dividends, consider reviewing your policy and the options available to you.

At Bair & Associates, we believe financial decisions should begin with education. If you have questions about your life insurance policy or want to better understand your options, we're happy to help you explore them without pressure.

Sometimes, making the most of what you already have starts with simply understanding it better.