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?

When do life insurance companies pay dividends?

Life insurance companies make certain financial assumptions every year. 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 project 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.

Do whole life insurance policies pay dividends?

This can vary from company to company. But typically a whole life insurance policy is eligible for dividends if a life insurance company pays them. This can be a great benefit over time as you may be able to use your dividend to purchase additional paid-up whole life insurance. Doing so can help you increase your death benefit and cash value more quickly than the guarantees built into the policy. And over time this can have a compounding effect as your additional insurance will be eligible for additional future dividends.

Do term life insurance policies pay dividends?

Again, this can vary from company to company. But some term life insurance policies are eligible for dividends. If dividends are paid for term life insurance, they could be taken as cash or used to reduce your premium.

Evaluating life insurance dividends

How is the 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 expenses and insurance costs are paid). 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.

Comparing dividends from different whole life insurance policies

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.

Does every insurance company pay life insurance dividends?

No. While most do, there are companies that do not. And even among companies that do pay regular dividends, it’s important to look at the company’s history of paying dividends because in many cases, dividends aren’t guaranteed.

Are life insurance dividends taxed?

Life insurance dividends are considered a return of premium and therefore are not typically taxed. Dividends paid are added to the basis when used to purchase additional insurance. Typically with a permanent life insurance policy you can withdraw the amount of basis you have paid into the policy tax free (although doing so will reduce your cash value and death benefit). Any growth will be taxed as ordinary income if you ever take it out of the policy.

Life insurance dividend options

When you get a dividend, you have several options. These include:

Dividends as cash

You could choose to take your dividend as cash. With this election, your insurance company will send you a check any time it pays a dividend.

Pay your premium

This can help to reduce what you’ll owe on your policy each year. And at some point, it’s not unusual for policies to grow to a point where the dividend can cover the entire cost of the life insurance for the year. Many people choose to reinvest their dividends into their policy.

Reinvesting life insurance dividends

Reinvesting dividends can allow the death benefit and 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.

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