Whole Life Dividends Explained

Whole Life Dividends Explained

There are certain kinds of life insurance policies that pay dividends to its policyowners. Generally, these dividend-paying policies are participating Whole Life insurance policies issued by mutual companies. Since a mutual insurance company is owned by its Whole Life insurance policyholders, it is customary for these mutual insurers to pay dividends annually back to its Whole Life policyowners.

Mutual insurance companies have paid dividends to policyowners for over 160 years.
Dividend-Paying Mutual Insurance Company building from the 1800’s

Regarding dividends, this article will explain:

  • What a dividend-paying Whole Life insurance policy is
  • When life insurance dividends are taxable
  • How to receive Whole Life dividends tax-free
  • The myth behind dividend interest rates
  • What makes up a Whole Life dividend
  • The different dividend options you have in Whole Life insurance.

Taxation of Whole Life Dividends

One would think that these dividends would be considered a distribution of profits and that the policyholder would have to pay taxes on these dividends.
However, since they are tied to a Whole Life insurance policy, these dividends are technically considered to be a refund of overpaid premiums by the mutual insurance company. Whole life dividends are therefore considered a tax-free return of premium up to the extent of how much premium you’ve paid into the policy. Life insurance is unique in that you can withdraw your basis (what you’ve paid into the policy) first and do so tax-free even though you may have experienced earnings in your policy.

Even after you have withdrawn dividends up to the amount you have paid premiums, you have a couple options to avoid paying tax on your Whole Life policy dividends.

  1. You can continue to let your earnings compound inside the tax-sheltered policy
  2. Or you can take a tax-exempt policy loan to continue to distribute the dividends that your Whole Life policy earns without having to pay any income tax.

As long as you keep your Whole Life insurance policy in force until the insured dies, then no tax will ever be due on your withdrawals, your policy loans, or the death benefit.

The Myth Behind A Company’s Dividend Interest Rates and Dividend History

Just the other day, a competing agent told my client that company A’s dividend interest rate was higher than company B’s dividend rate as if any meaningful information could be extrapolated from those figures.

You see, there is no standardized formula that all mutual companies agree to follow when declaring their annual Whole Life insurance dividend rates. Different companies have entirely different methodologies of calculating exactly how and when the dividend interest rate is applied. Each company differs as to how the actual dollar amount paid to their Whole Life policies is calculated.

Since there is no absolute value that translates apples to apples between different companies, this annual dividend interest rate is only valuable when comparing the same company in the past and in the present.

The image below was released in 2017 by a major mutual company’s competition desk showing the dividend history and movement of 8 different mutual companies between 1997-2017. We have blurred out the different company names to avoid legal hassles, but this gives you a visual example of how you can compare different companies’ relative movement and Whole Life insurance dividend history.

Below you can easily see if one particular company is trending with its peers or doing their own thing in a good way or a bad way. If you look down the columns vertically it shows green years where each company has raised their dividend interest rate (DIR), gray years where they have maintained their dividend interest rate, and red years where they have lowered their dividend interest rate.

Eight different dividend-paying mutual insurance companies as they raise, lower, or hold their whole life dividend rates for the 21 years
Whole Life Dividend History Chart

To see an example of a whole life policy over time, check out a video we put together titled “Fluctuating Dividends on a Historic Whole Life Policy from 1980-2017.” This short video goes back in time revealing the dividend history of an actual policy started in 1980 compared to the lower cash value and death benefit projections that were originally illustrated.

The 3 Distinct Components That Make Up Whole Life Dividends

The other misconception about Whole Life dividends is that the dividend interest rate is the only component that makes up a dividend. In fact, there are three different components, which we will discuss below. As the word dividend suggests, you are actually part-owner of the company that issued your policy. Therefore, you participate in all 3 of these distinct aspects of the company’s performance described below:

  1. Dividend interest rate – This component expressed as a credit comes from the profits from the mutual company’s other lines of business (term insurance, disability insurance, etc.). Whole Life policyholders also get a piece of the yield from the insurance company’s investment portfolio. In low-interest rate environments, insurance companies have been known to subsidize dividends with their surplus to remain competitive.
  2. Mortality Credits – This component of the dividend is expressed as a credit for having fewer death claims than originally anticipated when they originally underwrote all outstanding policies. Thankfully, due to the advances in medical science, the population’s average life expectancy continues to increase. Also, Mutual companies are often known to be tougher on underwriting and have consistently rewarded policyholders through this component of the dividend as a result.
  3. Expense Management – This factor reduces the credits earned from the other two dividend components above in any given year. As part owner of a mutual company by the nature of being a Whole Life policyholder, you share in the company’s operational expenses. How efficiently the company is managed each year determines how much or little they deduct from your dividend.

To see how all three of these components work in conjunction together, take a look at this schematic below that was put out by a very solid Mutual company. It’s an older piece, but still the best I’ve seen in explaining how Whole Life dividends work. It shows in different policy years how the actual dividend amount paid to Whole Life policyholders is calculated by tallying up the debits and credits from the 3 different components discussed above.

Shows how different components make up a Participating Whole Life Dividend from a mutual insurance company
Components of a Whole Life Dividend

What you can clearly see is that the “Interest Return” component of the dividend definitely will help to juice up the dividend, but it is not the only factor to be considered. It’s usually the only thing that clients ask about or that their agents will discuss. This is probably because the annual dividend interest rate is something simple that everyone can point to since all companies publish their own version of that figure every year.

As much as we would like to quantify it simply in our minds, Whole Life dividends are a lot more complex than that.

Remember that there is no consistent formula between companies when it comes to what part of the year they credit their dividends with interest. Not to mention, different mutual insurance companies vary with how much of the dividend pool each policyholder is entitled to based on current their cash value, death benefit amounts, and tenure in the policy.

Hopefully what you’re realizing through this schematic is that there are more pieces to the dividend puzzle than the dividend interest rate.

If you are trying to figure out who the most competitive company is, we recommend running the exact same premiums through several different mutual companies’ illustration software to see who is currently the most generous with their dividends. Equally important is a company’s guaranteed growth structure since this is the rails that compounding dividends will ride on. A savvy agent knows how to unbundle these factors in a comparative way for you to consider.

Click here to learn more about Whole Life’s Guaranteed Growth and 4 Ways to Accelerate it.

Since there is no way to be certain who will be the most competitive going forward, we recommend looking at those top mutual companies and taking a deeper dive into their dividend history, their financial strength, and any ancillary policy features to see which will best suit you. If you are planning on paying a substantial amount of premium, we even recommend diversifying your premium dollars between multiple mutual insurance companies for safe measure.

How to Use Your Dividend Once It’s Declared by a Mutual Insurance Company 

Once your annual Whole Life dividends are declared you have the option to use them in any of the following ways, and you can change how your dividends are utilized in any given year:

  • Dividends to Reduce premium – That’s right. Whole Life insurance dividends can pay your premiums. You can always apply your dividend payout dollar for dollar to reduce how much premium that you’re required to pay on your Whole Life insurance policy.
  • Dividends to Reduce Loans – You can apply your dividend payout dollar for dollar to reduce any outstanding policy loan balance.
  • Dividend in Cash Option – By electing the cash dividend option, you can have your Whole life insurance dividends paid to you outright in cash, and still have the rest of your cash value grow by the guaranteed annual growth rate even though you’ve stripped out that year’s dividend. Since Whole Life dividends are considered (by the IRS) to be a refund for an overpayment of prior premiums, the cash dividend option is not taxable to you so long as they do not exceed how much you’ve paid into the policy. (When they do eventually exceed how much you’ve paid into the policy you can still take distributions via a tax-exempt policy loan to continue receiving your dividends tax-free).
  • Dividends to Accumulate at Interest – I’m reluctant to even discuss this dividend option because the accumulate-at-interest dividend option sounds better than it is. It is absolutely the least efficient use of your Whole Life dividends. With “accumes” what happens is you roll your dividend payout back into the policy which increases your total guaranteed cash value going forward, but you have the insurance company pay you an annual taxable interest rate on your dividends. So although your dividends technically do accumulate-at-interest, this interest rate is often paltry, not to mention it would be taxable since you left the tax sanctuary of the policy. Once you learn about PUA’s below, let us never speak of “accumes” again, deal?
  • Dividends to Purchase PUAs (Paid-Up Additional Insurance) – Some of you are thinking, “I don’t want more insurance, I want maximum cash value growth!” Well, with PUAs you get both. It’s worth noting that even if your health has changed, there is no future underwriting for PUA’s purchased by dividends. You will still get the same health rating that you got on your original policy, however, the amount of paid-up death benefit you get will decrease slightly for every year you get older. When using dividends to purchase PUAs, only a very small portion goes to buying the paid-up insurance, and the lion’s share of the dividend payout will roll back into your policy cash value. It will be added to your guaranteed cash value, getting that steady growth rate every year going forward as well as helping you to claim a bigger cut of future dividend payouts. So, you get a double compounding effect for electing PUA’s, plus (unlike the accumulate at interest option) the growth you get from PUA’s remains sheltered from taxation inside the sanctuary of a Whole Life insurance policy.

Generally Prescribed Dividend Elections for Different Life Stages

Again, as a Whole Life policyholder, you can always change your dividend election each and every year as life changes or specific situations arise. Read our suggested dividend elections as you progress through these 3 common life stages.

1- Dividends During Your Accumulation Years

Unless there is some dire emergency where our clients need to use dividends to reduce premiums or loans, we generally recommend that clients choose PUAs as their default dividend option all the way up to their retirement age. That way they build up substantial guaranteed cash value as well as contractually paid up death benefit (where no further payments are due) at a very low cost. Doing so increases their cut of future dividend pools, and even though paid-up death benefit may not seem to benefit your retirement, it actually can come in handy with different advanced retirement distribution planning strategies.

2- Dividends During Your Distribution Years a.k.a. “Retirement”

Once clients are ready to retire, they are usually ready to stop funding their policy, and no longer want to pay back loans. We recommend switching future dividends to be paid in cash for a steadily increasing income stream (so long as dividends continue to be paid). Dividends are not guaranteed to be paid out annually. However, the most solid mutual companies have paid dividends each and every year for the last 150+ years in spite of recessions, depressions, world wars, inflation, deflation, etc..

Taking dividends in cash does not decrease your death benefit, yet your cash value still climbs each and every year on a guaranteed basis. If clients want a more aggressive income stream they can also surrender PUA’s purchased from prior dividends. This will obviously reduce your death benefit but may provide a much higher ongoing retirement income stream.

Once you have taken out more cash than you have put into your policy, you can always take a policy loan against what cash value is left in your policy to avoid taxation. So long as some minuscule amount of death benefit is in-force at the time of your passing, there is legally no tax imposed on any prior lifetime withdrawals, loans, or the death benefit itself. One Mutual insurance company offering Whole Life has even created a special rider called an “Overloan Protection Rider” to guarantee that your policy does not lapse from unpaid loans regardless of how long you live without paying back loans.

3- Dividends If / When Legacy Becomes your Priority

Keep in mind, that the general advice given above in sections 1 & 2 assumes that preserving and maximizing death benefit is not your priority. If at any time the insured finds his or herself in bad health, then they can change their dividend option back to purchasing PUAs to maximize the amount of tax-free death benefit left behind for heirs.

Although Whole Life dividends can be a great source of tax-free income during your lifetime, a Whole Life policy’s death benefit will always be greater than the amount of cash value you can spend while you’re alive.

Click here to have our team model your particular accumulation/distribution path using the leanest policy designs from multiple best of breed mutual companies with the strongest dividend histories.

John “Hutch” Hutchinson, ChFC®, CLU®, AEP®, EA Founder of BankingTruths.com
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