The Dividend Options and What Each One Does to the Contract

A participating whole life contract may pay a policy dividend each year, and the contract lets the owner choose what the insurer does with it. This page is about that choice: the five ordinary options, and what each does to the death benefit, the cash value, the premium, the tax attributes of the contract and its exempt status. It does not explain what a paid-up addition is, which is covered on its own page, nor how a participating contract works, set out separately, nor how the dividend scale is built, defined in the glossary.

Everything below is general information written by a licensed insurance professional. A policy dividend is not guaranteed, the dividend scale is set by the insurer's board each year, and past scales do not predict future ones. The tax consequences of an option belong to a Chartered Professional Accountant. Canadian Wealth Creation Centre Inc., trading as IBC Financial, is not authorized to give legal, tax or notarial advice and gives none here.

What are the dividend options on a participating whole life contract?

Five ordinary ones, and the contract names them. The insurer may pay the dividend as paid-up additions, pay it in cash, apply it to reduce the premium, hold it on deposit at interest, or use it to buy a term or enhanced coverage layer. Each does something different to the contract and to its tax attributes.

The options exist because a dividend is a distribution of surplus from the insurer's participating account, and surplus can be handed back in more than one form. The insurer's board reviews the experience of that account each year, in mortality, expenses and earnings on the backing assets, and declares a scale. Nothing about that declaration is guaranteed: the scale can rise, fall or hold, and one year's scale binds nothing about the next. A dividend is neither a return nor a rate, and any page or illustration that presents it as one is presenting something the contract does not say.

What the options share is a starting point. Whatever the board declares, the contract's own guarantees do not move: the guaranteed death benefit, the schedule of guaranteed cash values printed in the contract, and the premium are fixed at issue. The dividend sits on top of those guarantees, and the option decides where it lands.

What does the paid-up additions option do to the contract?

It keeps the dividend inside the contract. The dividend is applied as a single premium to buy a small, fully paid block of participating whole life insurance, which raises the death benefit at once, adds its own cash value, and itself participates in later dividends. The base premium does not change.

Three things move when a paid-up addition is bought. The death benefit rises by the face amount of the addition, permanently unless the addition is later surrendered. The cash value rises by the cash value of the addition, which follows its own guaranteed schedule. And the base for next year's dividend grows, because a paid-up addition is itself participating and the scale, whatever it is, applies to a larger contract than the year before. What a paid-up addition is, and how it differs from an additional deposit the owner chooses to make, is on the paid-up additions page.

This is the option the strategy relies on. The strategy is the Canadian application of the approach known as The Infinite Banking Concept®, originated by R. Nelson Nash; the mark belongs to Infinite Banking Concepts, LLC, with which this practice has no affiliation. The strategy depends on cash value compounding inside the contract over decades, and paid-up additions are how a declared dividend becomes part of that cash value rather than leaving the contract. The practice describes the aim of holding the highest practical level of control over the capital-flow function in one's own affairs as Infinite Financial Sovereignty®, and this option is the one consistent with that aim, without any promise as to the scale.

The tax attribute this option touches is the adjusted cost basis. Paragraph 148(2)(a) of the Income Tax Act excludes from the deemed proceeds of a dividend the part applied immediately to pay a premium under the policy, so a dividend applied to a paid-up addition produces no proceeds and no income in the year. The addition stays inside the contract, governed from there by the exempt policy rules discussed below rather than by annual taxation.

What do the cash option and the premium reduction option do?

Both send the dividend out of the contract rather than into it. The cash option pays the dividend to the owner as money. The premium reduction option, called premium offset when the dividend covers the whole premium, applies the dividend against the premium falling due. Neither raises the death benefit and neither adds cash value.

The cash option leaves the contract exactly as it was. The death benefit is the guaranteed amount plus whatever paid-up additions were bought in earlier years, and it does not rise. The cash value follows the guaranteed schedule plus the value of those additions, and does not rise either. The premium is unchanged. The owner receives a cheque; the contract receives nothing, and the compounding inside it gains nothing from that year's dividend.

The premium reduction option is the cash option with the money pointed at the premium. The contract still receives nothing new, the death benefit and the cash value are unchanged by the dividend, and the owner pays less from their own pocket that year. Where the dividend is smaller than the premium, the owner pays the difference; where it is larger, the surplus is applied as the contract provides, often as paid-up additions or cash. A contract on premium offset is a contract whose dividend is expected to cover the premium, and the word expected carries the whole weight, because the scale that makes the offset possible is declared one year at a time.

For tax purposes both options are a disposition. Paragraph 148(2)(a) of the Income Tax Act deems a policyholder who becomes entitled to a policy dividend to have disposed of an interest in the policy, with proceeds equal to the dividend less the part applied immediately to pay a premium or repay a policy loan. A dividend applied to reduce the premium pays a premium, so the deemed proceeds on that part are nil. A dividend paid in cash is deemed proceeds in full, and what those proceeds do to the adjusted cost basis is set out below.

What does leaving dividends on deposit at interest do?

It moves the dividend out of the contract and into an account the insurer keeps beside it. The insurer holds the money and credits interest at a rate it sets and can change. The death benefit and the cash value of the contract itself do not rise, and the premium is unchanged.

The deposit account is easy to mistake for cash value, and the difference matters. Cash value is a contractual attribute of the insurance, sits inside the exempt policy, and is what a policy loan is measured against. A deposit account is a side account: the owner's money, usually withdrawable on request, paid at death in addition to the death benefit. It buys no insurance, earns no later dividends, and does not compound inside the contract. It earns interest at whatever the insurer credits, which the insurer may revise.

The tax consequence is the plainest of the five. The dividend itself is a disposition under paragraph 148(2)(a) of the Income Tax Act when the owner becomes entitled to it, on the same footing as a cash dividend, since nothing in the paragraph treats a dividend held on deposit as applied to a premium. The interest then credited is interest, and paragraph 12(1)(c) includes in income any amount received or receivable in the year as, on account of, in lieu of payment of or in satisfaction of, interest, to the extent not included in a preceding year. The insurer issues a slip for it every year, withdrawn or not.

What does the term or enhanced coverage option do?

It uses the dividend to buy a layer of one-year term life insurance on top of the base contract, or, in an enhanced design, a mix of term life insurance and paid-up additions managed to hold a target death benefit. The death benefit rises by the coverage bought. The cash value rises only by any paid-up additions the design buys.

The names and mechanics vary between insurers. In the simplest version the whole dividend buys one-year term life insurance, and the coverage it buys depends on the dividend declared and on the term cost at the insured's attained age, so the coverage can change every year and can fall as the insured ages even if the dividend does not. In the enhanced version the insurer combines a smaller base contract with a term layer and, over time, replaces the term layer with paid-up additions as dividends allow, holding the total at a stated amount. The enhanced amount is not guaranteed; a scale that falls below what the design assumed can leave the insurer unable to hold it without more premium.

What this option does to the premium is why people choose it. For a given death benefit, a contract whose benefit is partly term coverage carried by the dividend costs less each year than one whose benefit is entirely guaranteed whole life. The other side is the cash value: the part of the dividend spent on term coverage buys one year of coverage and no cash value, so a contract on this option accumulates less than the same contract on paid-up additions. For tax purposes the dividend applied to the term premium pays a premium under the policy, and paragraph 148(2)(a) of the Income Tax Act keeps that part out of the deemed proceeds; how a term layer sits under the exempt rules depends on the insurer's design, and is a question to put to the insurer.

What are the limits and drawbacks of each option?

Every option gives something up, and the contract wording decides how much can be undone later. Cash ends the compounding the strategy relies on. Deposit creates taxable interest every year. Premium reduction stalls growth. The term option can require underwriting to enter later. Paid-up additions can press against the exempt line.

Start with what cannot always be reversed. An option that does not add coverage can usually be changed by an administrative request. A change into the term or enhanced coverage option after issue asks the insurer to carry more coverage than it underwrote, and the insurer can require evidence of insurability, and can decline. A contract issued on paid-up additions keeps its choices open in a way that a contract issued on cash, and later regretted, does not, because the additions not bought in the early years cannot be bought retroactively.

Then the cash option, the one most often chosen without thought. A dividend taken in cash is money in hand. But the contract loses the addition that dividend would have bought, the cash value that addition would have carried, and the dividends that addition would itself have earned on every later scale. The strategy is built on the second and third of those, and a contract on the cash option is one on which the strategy is not being applied.

The deposit option is the one most often chosen by people who believe they are keeping the money in the contract. They are not. The money is beside the contract, and the interest it earns is taxable in the year it is credited under paragraph 12(1)(c) of the Income Tax Act, withdrawn or not. A household that wanted growth without an annual slip has chosen the one option that produces one. Premium reduction produces no slip, but no growth either, and a contract on premium offset for many years has stood still for as long as the offset has run.

The drawback of paid-up additions is the least intuitive one. A contract that takes maximum paid-up additions year after year raises its cash value faster than on any other option, and section 306 of the Income Tax Regulations draws a line on how much accumulating fund a life insurance policy can carry and remain an exempt policy. A contract growing quickly approaches that line, and the insurer's adjustment to keep it exempt can mean increasing the death benefit, holding back part of a payment, or, if the wording allows nothing else, paying an amount out. That is no reason to choose a different option, but it is a reason to expect a letter from the insurer.

How does the Income Tax Act treat each option?

Through a single mechanism: a policy dividend is a deemed disposition, the proceeds are compared to the adjusted cost basis, and only the excess is income. Paragraph 148(2)(a) creates the deemed disposition, subsection 148(1) includes the excess in income, and element H of the definition in subsection 148(9) is where the dividend lands on the basis.

Take the three provisions in order. Paragraph 148(2)(a) of the Income Tax Act provides that where a policyholder becomes entitled to receive under a life insurance policy an amount as, on account of, in lieu of payment of or in satisfaction of, a policy dividend, the policyholder is deemed to have disposed of an interest in the policy at that time, with proceeds equal to the amount by which the dividend exceeds the part applied immediately after that time to pay a premium under the policy or to repay a policy loan under the policy, as the policy's terms provide. So the paid-up additions, premium reduction and term options, each applying the dividend to a premium, produce nil proceeds, and the cash and deposit options produce proceeds equal to the dividend.

Subsection 148(1) then does the counting. It includes in computing the policyholder's income for the year the amount, if any, by which the proceeds of the disposition exceed the adjusted cost basis to the policyholder of that interest immediately before the disposition. Where the basis exceeds the proceeds nothing is income; where the proceeds exceed the basis, the excess is income that year, and the insurer reports it. This is the sense in which a cash dividend is received without tax up to the adjusted cost basis and is income only above it, and the condition in that sentence is the whole of it.

The element that carries the dividend on the basis itself is element H of the definition of adjusted cost basis in subsection 148(9), verified at Justice Laws on the review date at the foot of this page. Element H is the total of all amounts each of which is the proceeds of the disposition of the policyholder's interest in the policy that the policyholder became entitled to receive before that time, and it is subtracted in computing the basis. A cash dividend, being deemed proceeds under paragraph 148(2)(a), enters element H and lowers the basis. As arithmetic and not as an illustration of any contract, a basis of 10,000 followed by a cash dividend of 1,000 becomes 9,000 with nothing in income, and a basis of zero followed by the same dividend produces 1,000 of income under subsection 148(1). The insurer keeps the running figure, and a Chartered Professional Accountant confirms what any year's slip means on a particular return.

What do the options do to the exempt status?

Only the paid-up additions option moves the contract toward the exempt line, because only that option adds accumulating fund inside the policy. Cash, premium reduction and deposit add nothing inside the contract. Whether a term layer affects the test depends on the insurer's design. The test itself is in section 306 of the Income Tax Regulations.

Section 306 of the Income Tax Regulations sets the condition under which a life insurance policy is an exempt policy at a time: in substance, that the accumulating fund of the policy, determined without regard to any policy loan, does not exceed the total of the accumulating funds at that time of the exemption test policies the regulation describes for it. Where a policy is exempt, the growth inside it is not taxed year by year under the accrual rules that apply to other life insurance policies; where it ceases to be exempt, that treatment ends. The regulation also directs, for a participating policy, the assumption that dividends will be paid as shown in the dividend scale, which is why a change in the scale can change the result. The exempt test page explains the mechanism in full.

The practical effect for a contract on paid-up additions is a test on each policy anniversary. Every addition raises the accumulating fund of the policy, and the exemption test policies it is measured against grow on their own schedule, so a contract funded to the maximum the insurer allows and taking every dividend as paid-up additions runs closer to the line than the same contract on any other option. Insurers build a contractual adjustment for that case, which may increase the death benefit so the test policies grow with it, hold back an amount, or apply the dividend differently that year. That is no reason to fear the option. It is a reason to read the anniversary statement and to have the insurer explain any adjustment in writing.

Who this suits, and who it does not

Paid-up additions suit a person who bought the contract for the cash value it will hold in twenty years and does not need this year's dividend. Premium reduction suits a household that wants lower outlay and accepts a contract standing still. The term option suits a person who wants more death benefit and accepts a layer carried by a scale that is not guaranteed.

It does not suit a person who wants growth inside the contract and chooses the deposit option, which puts the money beside it. It does not suit a person who expects this page to say what the dividend will be, because no page can, and the insurer's board decides that one year at a time. It does not suit a reader who wants the options ranked, because the answer changes with the reason the contract exists, and a page that ranked them would be selling rather than explaining. It does not suit anybody looking to take cash out of a contract without the adjusted cost basis moving, because element H of the definition in subsection 148(9) of the Income Tax Act does not allow it. And it does not suit anybody who needs to know what their own contract permits, which the insurer answers in writing.

Everything here is written by a person paid by commission from an insurer when a contract is issued, which is stated at the foot of every page. Insurance is insurance, it is not an investment, and a dividend option is a feature of a contract rather than a reason to own one. How a contract earns and pays dividends at all is on the dividend-paying life insurance page, and every tax question raised here belongs to a Chartered Professional Accountant with the contract's statements in front of them.