Paying whole life premiums with dividends: mistakes that bring bills back

The appeal of a premium offset is easy to state: after enough years, the dividends from a participating whole life policy can pay most or all of the bill, and the policy more or less carries itself. The trouble is that "more or less" hides a few places where the arrangement can quietly stop working, and the owner usually finds out when a premium notice arrives for an amount nobody expected. This post goes through seven mistakes that bring the bills back, how each one happens, what it costs and how to avoid it.

Throughout, the figures are invented and rounded, and they are labeled as illustrations. Your own contract and in-force illustration decide how your policy behaves. For the basics of the offset and the other dividend options, see life insurance dividend options: cash, paid-up additions and more.

First, what an offset is and is not

Under a premium offset, the insurer applies the annual dividend against the premium due, and you pay the difference. If the premium is $5,000 and the dividend is $4,200, you pay $800. The coverage, the cash value and the death benefit are exactly what they would have been if you had paid the full $5,000 and taken the dividend in cash. Only the flow of money changes.

Three features of that definition explain every mistake below.

1. The dividend is not guaranteed. It is a share of surplus that the insurer declares each year, and the scale can fall. See dividend scale.
2. The full premium is still owed. The offset reduces what you pay, not what the contract requires. If the dividend falls short, the shortfall becomes your bill.
3. The policy is not paid up. Unless the contract has reached a paid-up status, such as a limited-pay whole life: 10-pay, 20-pay and paid-up at 65 policy after its last premium, the policy remains premium-paying even in a year when you pay nothing.

Mistake 1: Starting the offset too early

How it happens. Dividends start small and grow. A salesperson may point to the year the illustration shows the dividend equaling the premium and say the policy will "pay for itself." An owner who is short of cash at year 8 switches from paid-up additions to an offset just because the option is available.

What it costs. Say the annual premium is $5,000 and the dividend in year 8 is $900. An offset cuts the bill by $900, or 18 percent ($900 divided by $5,000), and leaves $4,100 to pay. That is real relief, but it gives up something else. If the same $900 had bought paid-up additions, it would have added coverage and cash value, and every later dividend would have been calculated on a larger base. The projected dividend years later was partly built on those earlier additions. Stopping them lowers the later numbers the illustration used to show when the offset would start.

How to avoid it. Ask for the year the illustration expects the dividend to cover the premium in full, and look at what that year assumes. Keep dividends in additions until the offset is needed, not available. If cash is tight earlier, a partial approach can work, for instance using some of the dividend for the premium and the rest for additions, if the insurer allows it. The worksheet in choosing a dividend option: a worksheet to run with your own policy compares each option on your numbers.

Mistake 2: Ignoring a lowered dividend scale

How it happens. The offset begins when the illustration says it will, and the owner never checks whether the scale underlying that illustration still holds. A dividend notice arrives with the statement, the owner skims it, and the next bill is higher.

What it costs. The offset magnifies a drop in the scale because it leaves a small out-of-pocket amount sitting on top of a large dividend. In year 20, say the dividend is $4,200 and the premium is $5,000, so the owner pays $800. Now see what a scale reduction does:

Check the first row of arithmetic: $4,200 times 0.90 equals $3,780, and $5,000 minus $3,780 equals $1,220. A 10 percent drop in the dividend raised the out-of-pocket bill by more than half, and a 25 percent drop more than doubled it. The smaller your out-of-pocket amount, the more a modest change in the scale matters.

How to avoid it. Read the dividend notice each year. Ask for an in-force illustration that shows a scale one or two points lower than current, as described in how to request and read an in-force illustration, and budget for the bill under that scenario. A step-by-step response to a cut is in what to do when your whole life dividend scale is lowered.

Mistake 3: Borrowing against the policy while relying on the offset

How it happens. An owner who feels the policy is practically free takes a loan against its cash value, planning to leave it in place. The offset continues, apparently unaffected.

What it costs. Two things change at once. First, the loan accrues interest. A loan of $60,000 at an illustrative 5 percent charges $3,000 a year ($60,000 times 0.05), and that is a separate bill from the premium. If the interest is not paid, it is typically added to the loan balance, which then grows to $63,000 and charges interest on the larger amount. See policy loan interest and life insurance policy loans: how they work and what they risk.

Second, depending on how the insurer treats borrowed values, the dividend may be lower. Some companies credit a reduced dividend on the part of the cash value that is borrowed, a difference explained in direct and non-direct recognition loans: how borrowing affects dividends. In our example, say the dividend falls from $4,200 to $3,300 because of the loan. The out-of-pocket premium is then $1,700 ($5,000 minus $3,300), not $800. Add the $3,000 of loan interest and the owner's total cash outlay is $4,700, close to the full premium the offset was meant to eliminate.

There is a bigger danger beyond the cash. If the loan plus accrued interest grows to exceed the cash value, the policy can lapse. When a policy with a loan lapses, the loan can create taxable income even though no cash was received. The mechanism is described in rescuing a permanent policy when the loan outgrows the cash value.

How to avoid it. Treat the offset and a loan as competing uses of the same policy. If you must borrow, ask the insurer in writing how the loan affects the dividend and what the projected premium is with the loan outstanding. Put loan interest in the household budget as its own line.

Mistake 4: Not confirming that the offset stops cleanly

How it happens. The owner signs the form to change the dividend option, assumes it is done and does nothing else. Then one of several things goes wrong.

• The bank draft for the full premium keeps running, so the owner pays $5,000 and the dividend is separately credited or held, with no one noticing for a year.
• The reverse: the insurer begins billing only the net amount, and a bill for $800 sits in the mail while the owner expects nothing.
• The offset applies to the base premium but not to a rider premium, such as a paid-up additions rider, so a smaller but real bill still arrives.
• The change takes effect at the next policy anniversary, not the next dividend, so one more year of the old arrangement runs on.

What it costs. A missed or short payment starts the grace period, commonly about 30 days, and a policy that is not paid by the end can lapse or have an automatic premium loan applied, depending on the contract. See life insurance grace periods and lapses and automatic premium loans. An automatic loan keeps the coverage alive but starts a loan the owner did not choose.

How to avoid it. After any change, ask for written confirmation of four things: the effective date, the amount that will be billed, how it will be billed (draft, notice or online) and whether any rider or other charge is outside the offset. Then look at the next premium notice and compare it with that confirmation. If a bank draft is in place, ask the insurer to stop it or adjust it, and confirm the date it ends.

Mistake 5: Mistaking the offset for a paid-up policy

How it happens. The phrase "the policy pays for itself" turns into "the policy is paid up." An owner who has not paid a premium for five years may stop thinking of premiums at all, may not read statements and may be surprised when a scale change brings a bill.

What it costs. Aside from the surprise, there is a planning cost. An owner who believes the policy is paid up may make decisions on that belief: retiring earlier, dropping an emergency reserve or cutting other coverage. A policy that depends on dividends to avoid premiums is a policy with an obligation that is currently being met, not one whose obligation has ended.

How to avoid it. Know your policy's actual status. The statement should show whether premiums are still due and whether the contract is paid up. If you want a policy that will not call for premiums regardless of dividends, a reduced paid-up option is one way to get there, with a lower death benefit. See nonforfeiture options: reduced paid-up and extended term. Otherwise, think of the offset as a revocable arrangement that you will review each year.

Mistake 6: Forgetting the tax side

How it happens. Dividends feel like free money, and the premium offset hides them because no check arrives. Owners then do not track how much they have received, and years later find that the numbers matter.

What it costs. A participating dividend is generally treated as a return of premium, not income, until the total dividends received exceed the premiums paid. The excess is taxable. Dividends applied to the premium are part of that tally. For many policies the premiums paid will be larger than total dividends for decades, so the issue seldom arises early, but a very old policy with large dividends is a different case. Interest on dividends left on deposit is taxable each year. A tax professional can confirm how the rules apply to your policy; the general picture is in how cash value is taxed: withdrawals, loans and surrenders.

How to avoid it. Keep a running record: premiums paid, dividends received and how each was used. The insurer's annual statement or a year-end summary often shows both, and a call to the policy service line can fill gaps. Share the record with your tax professional when you surrender, exchange or take significant withdrawals, since the basis is the starting point for the gain.

Mistake 7: Having no cushion once the offset is in the budget

How it happens. A retired couple sets a monthly budget assuming the $800 out-of-pocket premium. Their income is fixed, so there is no slack, and they have no plan for a bill of $1,220 or $1,850.

What it costs. In a bad year, the policy competes with groceries and utilities. If the owner has to choose, the policy may lapse at the moment the owner is most in need of it, or the owner may reach for a loan to pay premiums, which sets up Mistake 3.

How to avoid it. Choose the budget figure from the stressed row, not the base row. In the table above, the owner who plans for the 25 percent case would set aside $1,850 a year instead of $800. If the extra is not needed, it can go to savings. If a bad year hits, the money is there. Revisit the number annually.

A setup checklist for an offset

Before you begin an offset, run through these steps.

1. Confirm the contract allows it and what the form requires.
2. Get an in-force illustration at the current scale and at a lower scale.
3. Decide the start date and ask the insurer to confirm it in writing.
4. Check how rider premiums, bank drafts and any policy loan are treated.
5. Set the household budget at the stressed figure.
6. Calendar a review for the month the dividend notice usually arrives.
7. Record premiums paid, dividends received and how each was used.

None of this is complicated, but each step closes one of the gaps above. The offset is a convenience, and its failure modes are mostly administrative or arithmetic, not mysterious.

When to ask for professional help

A fee-only planner can compare an offset with other uses of dividends and with the option of reducing coverage. A tax professional can address basis. The state insurance department can help if the insurer's billing does not match what it confirmed; the department's complaint process is the right channel for a dispute, and keeping your written confirmations makes that easier.

Key takeaways

• A premium offset changes who pays the premium, not what the contract requires; the full premium remains owed and the policy is not paid up.
• Starting too early gives up the compounding of paid-up additions, so wait until the offset is needed, not just possible.
• Because the out-of-pocket amount is small, a modest dividend cut hits hard: in our example a 10 percent cut raised the bill by 52.5 percent and a 25 percent cut by about 131 percent.
• A policy loan can lower the dividend and adds its own interest bill, so borrowing and relying on an offset work against each other.
• Get written confirmation of the effective date, billed amount and billing method, and budget for the stressed figure, not the base figure.