Dividend option, Dividend or Growth Option: Purpose, Suitability, Taxability
These four whole life insurance dividend options did not originate at the exact same time, but their existence as options spans an extremely long time.
Practically ever life insurer issuing dividend-paying whole life insurance today includes these four options. Dividend Option: Paid in Cash The option to receive the dividend in cash is pretty self-explanatory. Each year the life insurer pays the policyholder the dividend in the form of a check.
- There are a few different options one can choose from to disburse dividend funds.
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The payment comes directly to the policyholder who can then use the cash for whatever purpose he or she sees fit. Tax Code classifies the dividend payment on participating life insurance policies as a refund of premiums paid, so taking the dividend in cash does not usually cause an immediate taxable consequence to the dividend option.
This is the case because the dividend paid in cash is simply reducing the tax basis established by the policyholder's payment of premiums.
Eventually, however, opting for dividends paid as cash could remove the cost basis of the whole life binary option is the most reliable. If this takes place, all dividends paid moving forward will carry income tax consequences to the policyholder. An example will help clarify this concept. She opted for the paid in cash whole life insurance dividend option.
Also, note that if dividend payments do remove the cost basis any withdrawals from the policy will cause a tax liability as well. Policy loans continue to enjoy tax-free status so long as the policy does not violate the Modified Endowment Contract rules.
How to Invest in Mutual Funds? What Is a Dividend Option?
If the dividend payment is less than the total premium due, the policyholder will need to pay the rest of the premium either with money out of pocket or with cash values from the whole life policy. It's much more common for the policyholder to pay with out-of-pocket money.
Once the dividend payment equals or exceeds the premium due amount, the dividend can pay the entire premium due and the policyholder does not need to make any payment to the policy with any out-of-pocket money. Choosing this option does come dividend option some consequences all policyholders should understand.
First, the insurance company will require the policyholder to change the payment frequency to annual if it's not paid annually already. This is important for policyholders who pay premiums under some other frequency as it could cause a cash flow problem.
An example will help highlight this point. She decides that she wants to use the dividend option to reduce premium. Choosing the reduce premium option means Claire must change her payment frequency to annual.
The Fifth Dividend Option
Though the dividend payment is a refund of premium, using the dividend to pay ongoing premiums due creates an offset that leaves the tax basis static in all years a policyholder uses this option.
This means the cost basis will neither go up nor go down while using the dividend option to pay premiums.
If the dividend is smaller than the annual premium, any payment made with out-of-pocket money will increase the cost basis of the policy. It's also worth noting that dividend payments can and do fluctuate. So if the dividend payment covers your entire premium this year, it might not next year.
I bring dividend option up because life dividend option ledgers assume a constantly increasing dividend due to the assumption that the dividend scale remains static.
This is not how most whole life policies work in real life. Dividends do tend to grow substantially over time, but that growth is not always absolutely linear.
Lastly, know that this dividend option is somewhat unique given that there is a limit to the amount of dividend applied to this option. Once the dividend is larger than the premium due on the policy, the excess amount must go somewhere. In this case, the policyholder must choose a secondary dividend option.
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Paid-up additions are mini whole life insurance policies that attach to a main whole life policy. They earn dividends themselves and have immediate cash value. This dividend option will ensure the most bang for the buck in terms of premiums generating cash surrender value.