Life Insurnace Dividends

Understanding a Life Insurance Dividend, Interest & Capital Gain

A life insurance dividend can be compared to a stock dividend. Just as a profitable company may pay dividends to shareholders, mutual insurance firms can distribute year-end cash surpluses among some policy holders.

How Life Insurance Dividends Work

Mutual insurance companies generate income through life insurance premiums and investments. Based on the expected mortality rate among policy holders, firms then estimate how much cash will be needed to meet obligations and pay business expenses. At the end of the year, if expenses have been less than expected, or investments have done well, the firm will have a surplus. Some of the surplus may be paid back to policy holders.

Dividends Are Not Guaranteed

In practice, life insurance dividends are distributed only if a mutual company ends the year with a cash surplus. The board of directors will determine whether a dividend should be paid, and how much will be distributed to policy holders. Companies may use part or all of surplus funds to expand the business, pay other obligations, or increase investments. Firms also may choose to keep surplus cash in reserve to meet future obligations. In years when a firm’s life insurance payouts and other expenses exceed income, dividends are not paid.

Qualifying for a Dividend

Dividends are paid to policy holders of participating whole life insurance policies. Owners of these policies are roughly equivalent to stockholders in a corporation. They can vote for the board of directors, and are generally the only policy holders entitled to a dividend. Holders of term life and other whole life policies are not eligible. Some firms may offer hybrid policies that offer both term and whole life coverage. It’s important to carefully compare policy terms to determine whether dividends are offered. As a participating whole life policy can increase in value, it will cost more than other policies.

Applying a Dividend

When dividends are paid, policy holders have several options. Holders can use the dividend to help pay the next year’s premium, reducing the annual cost of keeping the policy. The dividend can also be used to increase the amount of life insurance coverage in the policy. Over time, reinvesting dividends can increase the value of a policy substantially. Policy holders may also ask the mutual fund to invest the dividend, keeping it separate from the policy, but potentially growing in value along with the firm’s investments. Finally, policy holders may take a cash payment for the dividend.

Taxes on Dividends

The IRS regards dividends as a rebate on premium payments. As a result, dividend income is not taxable, unless total dividend payments exceed the amount of premiums paid over the years. If dividend payments are invested with the mutual company, however, all interest earned is taxable each year.

IRS rules do classify some dividend payments as taxable income. The taxation is meant to penalize policy holders who quickly invest large amounts of money into their policies to avoid taxes. A mutual firm can advise policy holders on controlling the growth of policies to avoid triggering the IRS rules.