When a mutually owned life insurance company turns a profit, it can choose to add its profits to its reserves, or it can distribute the profits to the policy owners who collectively own the company in the form of a dividend. Term life insurance dividends can be paid by crediting the amount to the policy owner's premium, or paid in cash. Because whole life insurance policies accumulate cash value, however, they have more dividend options. State Farm allows policy holders to elect to accumulate dividends in a side fund; to take them in cash; to offset premiums, or to purchase additional insurance.
When you elect the "accumulate" option, the insurance company does not credit your dividend to your policy, your premium, or send it to you in cash. Instead, the insurance company keeps the dividend and invests it at a specified rate of interest. These dividends are generally taxable -- just as if you received the dividend in cash. The interest that accumulated dividends earn is also taxable.
If you elect to take dividends in cash, the insurance company will mail you a check, or wire the dividend to your account. Like the accumulate option, cash dividends are generally taxable.
If you elect to allow your dividends to purchase paid-up additions, your dividends are reinvested in your life insurance policy. Specifically, they buy small chunks of fully paid up life insurance, with no more premiums due. Depending on your age and health, these dividends can purchase chunks of life insurance at between $1.10 and $5 in death benefit for each dollar in dividends. This allows the death benefit of your whole life policy to increase over time. You can withdraw these dividends at any time, tax-free, in most circumstances -- provided your policy is not a modified endowment contract. Ask your agent if you are not sure whether your policy is a modified endowment contract.
If you elect premium offset, your dividends are credited against your premium for the year. You will pay a lower premium to keep the policy in force. After a whole life policy has been kept in force for a number of years, dividends may be enough to offset the entire premium. The whole life policy then becomes self-sustaining, provided the insurance company continues to pay a comparable dividend rate. Dividends are not guaranteed, however.
Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.