Important Things to Know
Dividend options for life insurance policies offer policyholders flexibility and versatility. The four original options are: receiving dividends in cash, using dividends to reduce or pay premiums, purchasing paid-in additions, and accumulating dividends with interest. Each option has its own tax implications and considerations, such as potential taxable income, impact on cost basis, and premium payment requirements. Less common options, such as long-term care benefits and index credit options, offer additional flexibility and potential for enhanced features.
Dividend Options: Four original options: cash payout, premium reduction/payment, purchasing paid-in additions, and accumulating with interest.
Availability of Dividend Options: Virtually every life insurance company that issues dividend-paying life insurance policies offers the four original options.
Tax Implications of Dividends: Each dividend option has different tax implications.
Dividend fluctuations: Dividend payments can vary from year to year, and this could change how policyholders can use various dividend options.
Innovative dividend options: Life insurers are developing new dividend options, such as long-term care benefits, to increase value for policyholders.
Dividend options for life insurance policies are one way to offer policyholders significant flexibility. Understanding these different options is crucial to properly using dividend-paying life insurance.
The continued development of dividend options, thanks to the creativity of insurance companies, is providing even more flexibility and versatility for life insurance policies. Today, I’ll detail the four options available with almost every dividend-paying life insurance policy. I’ll also introduce some other unique dividend options that few insurers offer.
The Four Original Dividend Options for Life Insurance
The original four options policyholders have for a lifetime dividend are:
- Cash payment
- Reduce/pay premium
- Purchase paid-in add-ons
- Accumulate interest
These four dividend options for life insurance did not emerge simultaneously, but their existence as options spans an extremely long period of time. Virtually every life insurer issuing dividend-paying life insurance today offers these four options.
Dividend Option: Cash Payment
The option to receive the dividend in cash is self-explanatory. The life insurer pays the policyholder the dividend annually in the form of a check. The payment goes directly to the policyholder, who can then use the money as they see fit.
US tax law classifies dividend distributions on participating life insurance policies as a refund of premiums paid. Therefore, the cash payment of the dividend generally has no immediate tax consequences for the policyholder. This is because the cash payment merely reduces the tax basis established by the policyholder’s premium payment.
However, if you choose to receive dividends in cash, this may result in the cost basis of the life insurance being eliminated. In this case, any future dividend payments will have income tax consequences for the policyholder.
An example should clarify this concept.
Sarah owns a 10-pay life insurance policy with a cost basis of $50,000 after 10 years. She has chosen the cash dividend option. Once the insurer pays Sarah a total of $50,000 in dividends, Sarah must report all future dividends as taxable income.
Also, note that with dividend distributions that eliminate the cost basis, withdrawals from the policy also trigger a tax liability. Policy loans remain tax-free as long as the policy does not violate the rules of the modified endowment contract.
Dividend Option: Reduce/Pay Premium
The choice to reduce the premium or pay with the dividend means the policyholder pays part or all of the premium due with the dividend. If the dividend payment is less than the total premium due, the policyholder must pay the remaining premium either out of pocket or with the cash value of the life insurance policy. Paying out of pocket is more common.
Once the dividend payment equals or exceeds the premium amount due, the dividend can cover the entire premium due without the policyholder having to make any out-of-pocket payments. This option is quite common with older life insurance policies because it allows the policyholder to maintain their death benefit without having to pay the life insurance premium.
Choosing this option has several consequences that all policyholders should be aware of.
First, the insurance company will require the policyholder to change the payment frequency to annual, if they don’t already do so annually. This is important for policyholders who pay their premiums at a different frequency, as it could lead to cash flow problems. An example illustrates this point.
Suppose Claire has a life insurance policy with a monthly premium of $1,000. She chooses the dividend option to reduce her premiums. In the year of this decision, the annual dividend on her life insurance policy is $3,000. The annual premium for her policy is $11,765. Choosing the premium reduction option means Claire must change her payment frequency to annual. Her dividend reduces the premium due by $8,765, which is due in one lump sum. If Claire doesn’t have the $8,765 to pay the premium all at once, the dividend premium reduction option is not a good option for her.
Although the dividend payment is a premium refund, using the dividend to pay ongoing premiums creates an offset that leaves the tax basis unchanged in all years in which a policyholder uses this option. This means that the cost basis neither increases nor decreases when using the dividend option to pay premiums.
If the dividend is less than the annual premium, any out-of-pocket payment increases the policy’s cost basis.
It’s also important to note that dividend payments can and do fluctuate. If the dividend payment covers your entire premium this year, it may not cover the next. I mention this because life insurance policies assume a steadily increasing dividend based on the assumption that the dividend scale remains unchanged. However, this isn’t how most life insurance policies work in reality. While dividends do increase significantly over time, this growth isn’t always linear.
This dividend option is unique because the amount of the dividend is capped. Once the dividend exceeds the policy premium due, the excess amount must be used. For example, with an annual premium of $10,000 and a dividend of $12,000, there is $2,000 left that cannot be used to pay the premium. In this case, the policyholder must choose a secondary dividend option. They simply choose one of the remaining dividend options, and the $2,000 is allocated to that option.
Dividend Option: Purchase of Paid-In Additions
The dividend option to purchase premium-free additions instructs the insurance company to take the annual dividend and use it to purchase premium-free additions. Premium-free additions are mini-life insurance policies attached to a primary life insurance policy. They generate dividends of their own and have immediate cash value.
This dividend option offers you the best value in terms of premiums that generate a cash surrender value. In other words, if you want to maximize the cash value accumulation of your life insurance, the option to purchase premium-free additions is the right dividend option for you.
This dividend option also allows life insurance policies to accumulate a non-guaranteed cash value. The non-guaranteed cash value of a life insurance policy is simply the cash value created by the premiums paid in. This “non-guaranteed” cash value is the only cash value the policyholder can withdraw from a life insurance policy.
Dividend Option: Accumulate Interest
The dividend option with accrual interest means that the insurance company deposits the dividend payment into an interest-bearing account and adds an interest payment to the account annually. The insurer sets the interest rate for these accounts annually and usually announces it along with other information about interest rates, such as loan rates, universal life rates, and annuity rates. If you are unable to find these announcements, a quick call to the insurance company may provide information about the current interest rate.
The interest rate may change annually, but all insurers set a guaranteed minimum interest rate for these accounts.
The policyholder cannot voluntarily contribute additional money to the interest-bearing account. For example, if a policyholder discovers that the interest rate for the interest-bearing option is significantly higher than that on their savings account, they have no way to transfer money from the savings account to the interest-bearing account with the insurance company. Only dividend payments can be transferred to the account.
The policyholder can withdraw funds from the interest account at any time. However, they cannot reinvest the funds into the account at a later date. After withdrawal, the account can only be replenished through future dividend payments on the life insurance policy.
You should understand that the interest account is not part of the life insurance policy and does not benefit from the favorable tax treatment associated with cash-value life insurance.
Interest from this dividend option is subject to income tax, just like interest on other cash accounts at banks or savings associations. The policyholder receives a Form 1099-INT at year-end listing all interest paid and must submit it with their tax return.
The life insurer does not grant a policy loan on the interest account. The accumulated value can only be withdrawn.
In the 1980s, interest on these accounts occasionally rose faster than dividend interest, and some people made extensive use of this option to maximize their interest income in certain years. While a return to a similar situation is always possible, this option generally lags behind the option to purchase premium-free supplements in terms of the total return on premiums paid into a life insurance policy, especially given the tax efficiency of the cash value held in a life insurance policy through the purchase of premium-free supplements.
The Fifth Dividend Option
As insurers evolve and become more creative in their product designs, a “fifth” dividend option has emerged that is quite common—though not as universal as the four options mentioned above.
This dividend option for life insurance allows the policyholder to use the dividend to purchase term life insurance. This option is generally the most efficient way to build a death benefit with a life insurance policy—at least in the short term.
The exact nature of this option varies from company to company. The type of term life insurance purchased is not the same across all companies. The amount of term life insurance you receive for a dollar can vary from company to company and changes as the insured ages.
Less Common Dividend Options for Life Insurance: The New Frontier
While it may not always seem like it, the life insurance industry is working hard to innovate and offer policyholders new features and benefits. In recent years, life insurers have developed additional features for life insurance dividends to increase value for their policyholders. These options are by no means universal and are often exclusive to only one or a few life insurers.
Long-Term Care Benefits
This dividend option is perhaps one of the most urgently needed benefit options, creating a pool of funds for long-term care needs. The insured must meet similar requirements to qualify for the benefit as for long-term care insurance (e.g., loss of activities of daily living or severe cognitive impairment).
Essentially, this option uses all or a portion of the dividend to fund long-term care insurance linked to the life insurance policy. This reduces the high cost of long-term care insurance premiums associated with traditional individual policies, but typically loses some of the benefits of traditional long-term care insurance products.
Index Credit Option
This option aims to incorporate the benefits of indexing, primarily found in certain universal life insurance policies, into a whole life insurance policy. It results in a change in the regular dividend payout to the policyholder if the policyholder is willing to make the dividend amount fully or partially dependent on the success or failure of a market index over a specific period (usually one year). This can significantly increase the dividend payout. However, it can also result in a significantly lower dividend payout in a given year if the underlying market index performs poorly.
