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Life insurance is like ice cream, it comes in lots of flavors, and no form is clearly better than the rest. While term policies tend to be the cheapest, whole life insurance policies provide a variety of advantages like death benefits, predictable premiums, and, as we will discuss today, dividend options.
Participating Policy Contracts
Insurance terminology can be intimidating and confusing but they don’t have to be. “Participating Policy Contract” is one of those terms that sounds a lot more complicated than it actually is. Breaking the term down will make it easier to understand.
All insurance policies are contracts, which means they are agreements between the policy owner, you and the insurance company. The contract in this case boils down to this: you promise to pay a regular premium for a set amount of insurance, and the insurance company promises to pay the face value of the policy (contract) to your beneficiary upon your death.
The participating part in this case refers to your participation in sharing in the profits of the insurance company. Participating policies are usually a whole life policy that pays dividends. The dividend is a portion of the insurance company’s profits that are paid to policyholders as if you were an investor or stockholder. The policyholder is generally offered several choices of what to do with the dividends when they are paid.
Participating policies are usually a whole life policy that pays dividends
Participating policy dividends may be used in a number of ways:
- Taken as Cash – The insurer sends you a check for the amount of the dividend.
- Premium Reduction – The amount of the dividend is deducted from your premium.
- Savings – Dividends may be left with the insurance company to earn interest.
- Purchase More Insurance – May be used to purchase additional paid up insurance.
Not All Policies Guarantee Dividend Options
Dividends are shares of the insurance company’s profit, and as anyone who watches the stock market will tell you, profits go up and down, which means dividends can and will vary over time. Participating policies even from the same provider may be different, which is why it is very important to ask and read your contract. When companies guarantee a dividend, it usually means a higher premium – a portion of which is ultimately used to pay you.
Participating policies even from the same provider may be different, which is why it is very important to ask and read your contract
Good, Better, Best
Not all insurance companies are created equal, and when you consider purchasing a participating policy, an important consideration should be the relative strength of the insurer. A.M. Best and Standard and Poor’s both employ analysts whose sole job is to watch over insurance companies and grade their performance.
The higher a company’s rating, the more likely they will pay the projected dividends being offered. The difference between an A, AA and AAA rating may not be significant enough to sway you from choosing one insurer over another, but the differences may become substantial when you drift below an A rated provider.
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Not all insurance companies are created equal, and when you consider purchasing a participating policy, an important consideration should be the relative strength of the insurer
Dividends are calculated differently by different companies, however they are generally based on the current cash value of your policy. Northwestern Mutual’s dividend formula is a simple and effective way to get the right number. Consider these numbers using it:
$58,367 cash value
X 3.29% interest rate
$ 1,923 your dividend
The advantage is that over time as your cash value increases, your dividend increases as well. You may never get rich from participating insurance dividends, but they can go a long way to increasing your coverage or paying down your premium. As you might expect, they require time and patience to reap the reward.
Dividends earned from a participating life insurance policy are not taxable by the IRS
Dividends earned from a participating life insurance policy are not taxable by the IRS. Participating policy dividends are not taxable as income because they are not dividends in the traditional sense. While they do represent a portion of the insurance company’s profit, that profit was made from you. In essence, the IRS treats them as though they are refunds for overpayment of premium.
The Bottom Line
All life insurance is an investment in the financial well-being of your loved ones. Participating Life Insurance provides a modest benefit while you’re alive and can work to your advantage by reducing your premiums, or buying additional paid up or term insurance. The cost of a participating life policy is higher than a non-participating policy, and both of these policies are significantly higher than a term life policy.
The bottom line when deciding what type of policy is right for you is to consider all of your personal factors such as:
- Current coverage needs
- Cost per unit of coverage ($100,000 – $250,000 – $500,000)
- Your health and other risk factors
- Your age
- Your anticipated future needs
Learning and understanding your options is the first and most important step to creating a solid foundation on which to construct your future protection.