“It pays dividends.” That’s a common turn of phrase when something’s a good investment. But there’s one category of finance that pays dividends, while not technically being an investment. That’s life insurance. Certain policies might pay out a dividend benefit while you’re still alive, which probably seems counter-intuitive to the reason you got the policy in the first place: for estate and tax planning purposes.
When life insurance policies pay dividends, this can create a new tax burden for the person who owns the policy. One way that people work around these life insurance dividends is to use them for charitable giving, which can create a lucrative write-off while allowing the recipient to support a cause they care about.
How Life Insurance Pays Dividends
Generally, a life insurance policy that pays dividends is referred to as a participating whole life policy. “Participating policy” means that you are participating in the profits made by the insurance company. The insurance company will see profits from the investments made, favorable mortality estimates, and other reductions in expenses. How much you get to participate in the profits will be outlined in your contract.
When dividends in a policy are paid, you’ll have the option of taking them out in cash or leaving them within the policy. While cashing them out is obvious, leaving the funds in the policy might mean applying the dividends to premiums due.
In an older whole life insurance policy, those dividends may be enough to actually cover the cost of the premium entirely. That could free up enough funds to purchase a new insurance policy for the benefit of the charity, which is a better way to leverage those dividends to give the charity a higher return.
The other option is to assign the dividends to the charity of your choice. This might sound simpler but it ultimately leaves the charity with a lower dollar amount because they won’t get the full benefit of a policy. They’ll only receive occasional periodic payments with no growth. That’s why it’s a much better idea to use the dividends to pay down the premium, while purchasing a new policy and gifting that policy to the charity.
Leverage the Dividends by Paying Down the Premium
To offer the most economic benefit to a charity, you can either leverage the dividends to pay off the old premium and gift that policy, or use the financial leverage from those dividends to purchase a new policy.
In either case, the policyholder would elect to roll any existing dividends back into the premium, with the hopes that the dividends would be able to sustain premium payments. If the dividends are enough to sustain the entire premium payments, at that point, you’d want to gift that policy to charity.
The next option is to apply the dividends to the old policy and use the money you’ve saved on the premium for that policy to purchase a new one, through a trust, with the charity listed as the beneficiary. In this arrangement, you’re relieved of the majority or entirety of the old premium obligation and can pay whatever amount is comfortable for the new policy, whether it be term or permanent insurance.
Choosing the Right Recipients
In order to take advantage of the charitable write off you get from gifting those insurance policies, you have to choose a qualified charitable organization. Under IRS criteria, that charity would have to fall into one of the following categories:
- Cities, states, and US possessions
- War veterans organizations
- Religious organizations
- Civil defense organizations created within federal, state, or local law
- Funds set up for charitable, religious, scientific, literary, or humanitarian program funding
- Nonprofit volunteer fire companies
- Fraternal societies (to support the society’s own charitable efforts only)
- Cemetery donations
Contributions to one of the above organizations can be deducted for up to 50% of your adjusted gross income for the year, though limitations will apply if you take an individual net operating loss deduction. Also, the limit on certain charities is 30%, rather than 50%. The amount you get to write off on a gifted life insurance policy with premiums still being paid is the approximate cash value of that policy.
As long as the dividends stay within the policy, and those policies are owned through a trust, you shouldn’t have any additional tax issues to deal with. Dividends used to fund premiums aren’t considered taxable, and life insurance held by a trust keeps those policies out of your estate.
Leveraging your dividends to help give to charity can be a great way to reap the benefits of your whole life insurance policy. These dividends are already tax-friendly, but can be used to reduce your taxes now and in the future. To see how you can get your whole life insurance dividends to “pay dividends,” contact a Howard Kaye advisor today at 800-DIE-RICH.
