If you’re thinking about buying permanent or whole life insurance, you may have heard the word dividends. They sound like a good thing — after all, dividends are extra money that’s paid out to you. But what are they really and how do life insurance dividends work?

WHAT IS A LIFE INSURANCE DIVIDEND?

Life insurance companies make certain financial assumptions. For instance, they plan for how many claims they will pay, called mortality. They anticipate making a certain amount on the money they invest. And they set expenses, i.e., how much it will cost to run the company.

When a company finishes the year better than expected, it can choose to pay some or all of that money back to shareholders and policyowners in the form of a dividend.

Some life insurance companies don’t even have shareholders; those companies are called mutual companies (Northwestern Mutual happens to be one of those). So at mutual companies, dividends are paid solely to policyowners.

HOW IS A LIFE INSURANCE DIVIDEND CALCULATED?

When you buy permanent life insurance, you pay a yearly premium for your policy. Each year, that premium is added to your policy and becomes cash value — money that you can access for any reason during your lifetime. After the premium is added to your cash value, expenses to pay claims and operate the company are subtracted. Then, interest is credited based on a guaranteed rate. If the company’s experience is better than assumed for expenses, claims (mortality), and investments, a dividend is generated. You can learn more about Northwestern Mutual’s dividend here.

WHAT CAN I DO WITH MY LIFE INSURANCE DIVIDEND?

When you get a dividend, you have several options. You could take the money as cash. Or you could use it to pay your yearly premiums. However, many people choose to reinvest their dividends into their policy.

WHAT HAPPENS WHEN YOU REINVEST DIVIDENDS?

Reinvesting dividends can allow the cash value of your policy to grow more quickly over time. That’s particularly beneficial because this growth compounds and is typically tax-deferred, similar to the way your contributions to a traditional 401(k) grow.

WHAT QUESTIONS SHOULD I ASK ABOUT DIVIDENDS WHEN BUYING LIFE INSURANCE?

Make sure you ask about all the components of the dividend (mortality, expenses and interest rate). Just because one company’s dividend interest rate is higher than another’s doesn’t mean the actual dividend amount that you get will be higher. For example, it’s possible that a company doesn’t perform as well from a claims or expenses standpoint. If that’s the case, they could have a higher interest rate than another company but end up paying a lower dividend. That's why it’s so important to see the whole picture before you make a decision on which policy to buy.

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