Dividends: “A refund of premium. Dividends reflect company claim, expense and investment experience that is more favorable than was assumed in determining premiums and guaranteed values. Illustrated dividends are not estimates or guarantees of future results. Dividends earned on personal insurance are generally not considered taxable income until all dividends received exceed all premiums ever paid.”
This is a glossary definition from Northwestern Mutual’s brochure dated May 2003. An insurance dividend is simply a return of premium. In other words, a company will charge an excessive premium and give back the difference at the end of the year if there is any profit left over. The difference between stock dividends and insurance policy dividends is that the insurance company dividends are not taxable in most cases. The IRS does not tax money that is given back to you.
There are very few dividend paying companies left today. Most have switched to a publicly traded stock company. The profits are paid in stock dividends and shareholder equity. If you are going to buy or own a dividend paying policy, there are different options you need to know about. Most people do not realize you have choices and you can make changes in these options.
Cash: They send you a check directly to you every year that they pay a dividend.
Accumulate: The dividends are put in an account administered by the insurance company. The interest rates historically have been very low. There are taxes due on interest paid on the dividend account.
Paid-up Additions: This option is used to buy more life insurance on you every year as the policy matures. This option is the one most often used in this area. Every year the insurance company takes your refund check (dividends) and buys more life insurance for you. This thinking, in my opinion, is backwards in most cases. You need the most life insurance when you are a parent and have kids at home. It takes a lot more life insurance to raise kids and pay off mortgages than it does to pay for a funeral.
If you have dividends paying life policy, you can take the dividends out without affecting the guaranteed values. There is usually no penalty. Check your policy to see what dividend option you have. If the insurance company is buying more life insurance on you and you do not need any more, a reduced premium might help with the budget right now.
I will write more at a later date about Paid Up Policies. It’s true that you do not have to pay a premium to the insurance company directly. There is some opportunity cost involved in owning those policies.
It’s always good practice to review your life insurance policies with a professional. Are you taking full advantage of your retirement plan at work? Do you have a Roth IRA or traditional IRA? It might be worth your time to review you life insurance and see if any of your premiums could be better utilized in true retirement plans. Make it a wealthy year.
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