by Richard F. O’Boyle, Jr., LUTCF, MBA
Whole Life Insurance is permanent life insurance designed to last through your life expectancy. The premium remains fixed and level as long as you own the policy. The policy’s cash value grows at a guaranteed rate and may also accumulate dividends. Dividends may be declared each year by the insurance company.
When the mutual insurance company has a surplus after paying claims and expenses, the Board of Directors may elect to pay a dividend to participating policyholders. In the technical sense, dividends are a return of premium to the policyholder on the policy’s anniversary date. Since they are a return of premium, they are not taxable as income (unless the dividend exceeds the premiums paid).
There is never a guarantee that a dividend will be paid in a given year. The amount of dividends paid depends on a few factors, primarily the mortality assumptions made by the company (did fewer people die that year than expected) and the prevailing interest rate and investment environment (did the company’s investments produce a higher return than expected).
Life insurance agents may provide an illustration of a whole life policy that shows the inclusion of dividends in future years. The illustration assumes that the insurance company pays the same dividend rate, which may not come to pass. If dividends are reduced in the future, the cash values will be smaller over time.
Once a dividend is declared by the company, the policy owner has several options. Dividend options can be changed throughout the life of the policy:
1. Take the dividend as cash: The policy owner receives a check for the total dividend amount.
2. Leave dividends on deposit: The dividends accumulate interest at a market rate (the interest is taxable as ordinary income).
3. Reduce the out-of-pocket premium payment: The dividends are used to pay the annual premium in part or in full. Since dividends may rise or fall (or not be declared at all), future premium payments can not be guaranteed. The owner may be required to restart paying some or all of the premiums if no dividend is declared in a given year.
4. Repay policy loans: Dividends may be used to pay loan interest and/or principal.
5. Purchase paid-up additions: These are small “single premium” life insurance policies with their own death benefit, guaranteed cash values and dividends. The accumulation of these paid-up additions will greatly accelerate the future death benefit and cash values of the policy.
Direct Recognition is a method for calculating a whole life policy’s dividends. The insurance company generally adjusts downward the dividends for each policy if there is an outstanding loan. The prevailing interest rate for policy loans factors into the dividend calculation. Each company computes the actual dividend differently, so accurate comparisons between whole life policies should be handled by your agent.
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