When discussing whole life insurance with a mutually owned life insurance company, dividends naturally come into the conversation. You might wonder, what exactly is a dividend and how do life insurance dividends differ from investment dividends? That’s exactly what we are going to cover today.
There are some key distinctions between life insurance dividends and investment dividends. An investment dividend is a distribution of profits from a company to its shareholders, and these dividends are taxable. However, life insurance dividends are a return of overpaid premiums and are not taxable. This is a crucial distinction.
One reason we always talk about paying income tax on the premiums is that you never want to take a deduction for your life insurance premium, even if it is for business purposes. Doing so could lead to your death benefit—the large sum of money that goes to the beneficiary—becoming taxable. It’s vital to ensure that everything is aligned properly to get the most out of life insurance.
The premiums you pay are small contributions towards the huge death benefit. If the premiums are deductible, the death benefit becomes taxable, and you don’t want that. By paying premiums with after-tax dollars, you maintain the tax advantages of the death benefit. Dividends, on the other hand, are used to enhance your policy’s cash value growth. Although dividends are technically a refund of overpaid premiums, they can be seen as profits because if you have a policy with a mutual insurance company, you essentially become an owner of the company.
With whole life insurance, policies are designed by actuaries, who typically overestimate the amount needed, which is why dividends are built into the policy. When you see an illustration, you’ll notice two sets of numbers—the guaranteed figures representing the worst-case scenario (if no dividends were ever paid) and another set based on the current dividend rate, showing how the policy could perform if dividends are paid consistently over time.
Reinvesting dividends into the policy by purchasing paid-up additions is a smart strategy. This allows you to earn interest on the dividends, which in turn increases future dividends. Over time, this compounding effect builds long-term value, with dividends being smaller in the early years and much larger in the later years.
Life insurance companies make two promises with a whole life policy. First, to pay out the death benefit when the insured dies, and second, to have the cash value equal to the death benefit by the policy’s maturity, which is usually age 121. As the policy matures, the cash value grows exponentially. If you add dividends into the mix, this process accelerates, making the policy more efficient over time.
One key thing to remember is that dividends are not guaranteed. When you get your policy illustration, the figures showing the dividends are based on the current rate, which is subject to change. However, once a dividend is earned, it’s yours—there is no risk of losing that dividend or the associated cash value, even if no future dividends are paid.
Although dividends aren’t guaranteed, many mutual insurance companies have been paying dividends for over 125 consecutive years, even through significant events like world wars, depressions, and economic downturns. While the dividend projections may not always be met, companies generally do pay something.
As the owner of the policy, you have the contractual right to choose how your dividends are allocated. You can use them to reduce premiums, take them as cash, or purchase paid-up additions.
If you’d like to learn more about how to apply this process to your business, family, or personal finances, visit our website at tier1capital.com. We’d love to speak with you in a free strategy session.
Remember, it’s not how much money you make; it’s how much money you keep that really matters.
