There are many different life insurance policy options, ranging from comprehensive whole life policies to term policies with a limited duration. Although term policies are usually the least expensive form of life insurance, whole life policies offer several benefits that policyholders may consider when purchasing coverage.

These include a guaranteed death benefit, predictable premiums over time, and even dividends that can provide cash or help offset life insurance costs over time.

What Are Dividends?

Many whole life insurance policies provide dividends representing a share of the insurance company's profits paid to policyholders. These dividends are similar to traditional investment dividends that represent a share of a public company's profits.

The dividend amount often depends on the amount paid into the policy. For example, a policy worth $50,000 offering a 3% dividend will pay the policyholder $1,500 per year. If the policyholder adds another $2,000 in value during the following year, they will receive $60 more, for a total of $1,560 the next year. These amounts can grow over time to levels sufficient to offset some costs associated with premium payments.

Whole life insurance dividends may be guaranteed or nonguaranteed depending on the policy, so reading the plan details carefully before purchasing a policy is essential. Policies providing guaranteed dividends often have higher premiums to compensate for the insurer's additional risk. Those offering nonguaranteed dividends may have lower premiums, but there is a risk that no dividends will be paid in a given year.

Using Policy Dividends

There are many different ways to use whole life policy dividends, ranging from receiving a check in the mail to purchasing additional insurance. The most common uses include:

• Cash or check: A policyholder can request that the insurer send a check for the dividend amount.
• Premium deductions: A policyholder can request that the dividend be applied to future premiums due to offset the cost.
• Additional insurance: A policyholder can use the dividend amount to purchase additional insurance or prepay their policy.
• Savings account: A policyholder can choose to leave the dividend with the insurance company to earn interest on the amount.

The good news is that dividend payments received from participating life insurance policies are generally not taxed by the Internal Revenue Service (IRS), since insurance companies generated the profits from their policyholders. Dividends received from a life insurance policy are treated as a distribution from the contract and taxed similarly to other types of distributions. Dividends are distributed free of income tax until the taxpayer's investment in the contract has been reduced to zero. (Dividends reduce the owner's investment in the contract.)

Because insurance companies generated the profits from their policyholders, dividend payments are essentially treated as refunds of premium overpayments. This means that the best option is often to take the dividends in cash or by check and reinvest the proceeds in an investment vehicle that could generate more income.

KEY TAKEAWAYS

• Permanent life insurance policies often pay dividends to their policyholders regularly.
• Dividends received are based on the company's financial performance, including interest rates, investment returns, and new policies sold.
• Dividends can be distributed in cash, used to purchase additional paid-up insurance, or applied to reduce premiums due.
• The dividend amount is tied to the price of the premiums paid by the policyholder.
• The larger the dividend, the more expensive the policy.

Many whole life insurance policies pay dividends to policyholders that can be used in different ways. When evaluating insurance policies, people should investigate how dividends are calculated and whether they are guaranteed, as well as how they plan to manage dividend income. Favorable tax treatment means the best option is often to take the cash and reinvest it elsewhere for a better return.

Also, because a good insurance policy is more than its dividends, be sure to review the entire plan to verify that it is the best life insurance policy for your circumstances.