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Dividends are paid only on participating policies. A policyowner who buys a participating policy actually pays a "grossed-up" premium — a bit more than what strict actuarial pricing would require — to give the insurer a safety margin in case its losses run higher than expected. Whenever that safety margin turns out not to be needed, whether because mortality experience was better than assumed or because the company's investment earnings beat its assumptions, the insurer returns the excess to policyowners as a dividend. Because a dividend is simply a return of the policyowner's own excess premium, it is not taxable, and insurers can never guarantee dividends in advance.
A policy's first dividend may be paid as early as the first policy anniversary, but must be paid no later than the end of the third policy year; after that, dividends are typically paid annually. Policyowners can choose from several different ways to receive their dividends.
Dividends are a return of excess premium, which is why they are not taxable when paid directly to the policyowner.
The simplest option: the insurer mails the policyowner a check for the dividend amount as it is declared, usually once a year.
The dividend is applied against next year's premium, lowering how much the policyowner has to pay out of pocket.
If a policyowner's annual premium is normally $1,200 and the insurer declares a $150 dividend, the policyowner would only owe $1,050 for that year's premium.
The insurer holds the dividend in an interest-bearing account on the policyowner's behalf, crediting interest at a rate specified in the policy and compounded annually; the policyowner may withdraw the accumulated dividends at any time. While the dividends themselves are not taxable, the interest credited on those dividends is taxable in the year it is credited, whether or not the policyowner actually withdraws it.
The dividend is used to purchase a small amount of additional, fully paid-up permanent coverage layered on top of the base policy's face amount — no separate policy is issued. Each of these paid-up additions builds its own cash value and can itself generate future dividends, and how much extra coverage a given dividend buys depends on the insured's attained age when the dividend is declared. If the policyowner never elects a dividend option, the insurer will automatically apply dividends as paid-up additions.
The dividend purchases a small amount of one-year term insurance, layered on top of the base policy's death benefit for that year only. A policyowner may either apply the dividend to buy as much one-year term as it will fund, or use it to buy one-year term equal to the policy's cash value for as long as the dividend will support it. If the insured dies during that one-year term, the beneficiary collects both the base policy's death benefit and the death benefit from the one-year term insurance.