The Dividend Options and What Each One Does to the Contract

If you own a participating whole life policy, or are looking at one, the dividend option is the standing instruction that tells the insurer what to do with each dividend it declares. There can be five or six possible destinations, and each leaves a different mark on the death benefit, the cash value, the premium you pay and your tax. Choosing an option does not change the guaranteed values of the base policy printed in your contract. It decides where the part that is not guaranteed lands, although leaving an enhanced option can change the coverage that option was carrying, as explained below.

Already own a policy? Find your current election on your latest annual statement, then use the tables below to list what to confirm with your insurer. To go straight to the comparison, see the options at a glance. For the question many owners ask later, see premium offset: can premiums come back?

This is general information written by Jose Salloum, who is licensed to sell life insurance and is paid by commission from an insurer when a policy is issued. Services come only from Canadian Wealth Creation Centre Inc., which is not authorized to give legal, tax or notarial advice and gives none here. The general Canadian tax rules are explained below; an accountant confirms how they apply to your return. Related pages: what a paid-up addition is, how participating whole life works and how the dividend scale is built.

The options at a glance

Canadian participating contracts commonly offer some combination of the options below. Not every product offers every one, some limit the choice in the early years or during an enhanced period, and the dividend option provision in your issued contract decides. Read the two tables as a map of common elections, not as a promise about your policy.

What this year's dividend does to the policy:

Tax, flexibility and what to confirm:

The first table shows why the choice matters over decades: only additions, and the addition part of an enhanced design, put new permanent value inside the policy. The second shows why it matters at tax time: cash and deposit dividends are counted against your basis, while a dividend applied to a premium is not counted at all. Each row is explained below.

What stays fixed, and who decides

The issued contract sets its guaranteed base coverage, its schedule of guaranteed cash values and its required base premium for the payment period you chose. Riders, later changes and a dividend-funded premium offset can change what you actually pay or receive, so the guaranteed column of your own contract is the reference. Choosing a dividend option does not change that guaranteed schedule. It decides only where the dividend goes.

The dividend itself comes from the insurer's participating account. Each year the insurer's board reviews the account's experience in mortality, expenses and investment earnings on the assets behind it, and declares a dividend 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 an interest rate, and an illustration that presents it as one is presenting something the contract does not say. How a policy earns dividends at all is explained on its own page.

The insurer pays the dividend to the policy owner, and the owner elects the option. That is not necessarily the person insured, and never a beneficiary or a relative who holds no ownership. If you own a policy on your spouse or your child, the election is yours to make and yours to change, within what the contract allows.

Paid-up additions: the dividend stays inside the policy

This option applies the dividend as a single premium to buy a small block of fully paid participating whole life insurance. The purchase raises the death benefit at once and adds cash value of its own. Your base premium does not change.

Three things move when an addition is bought. The death benefit rises by the face amount of the addition, and stays higher unless the addition is later surrendered. The cash value rises by the addition's own cash value, which follows its own guaranteed schedule. And the addition can itself share in future dividends under the contract. Neither that future dividend nor any proportional increase is guaranteed; the insurer allocates dividends by its own method for each block of policies. How an addition differs from an extra deposit you choose to make on top of the premium is set out on the paid-up additions page.

Why do some owners care so much about this option? Some use participating whole life as the tool in a financing strategy: over the years they take policy loans from the insurer against the cash value to pay for things in their lives, then repay them on a schedule they commit to. The loan is an advance from the insurer, secured by the policy, and the interest is paid to the insurer. Paid-up additions matter to that use because they raise the cash value that a policy loan is measured against.

The idea behind that strategy is The Infinite Banking Concept®, which Nelson Nash set out in Becoming Your Own Banker®. The Infinite Banking Concept® is a registered trademark of Infinite Banking Concepts, LLC; neither this practice nor its author is affiliated with, sponsored by or endorsed by that company, and no policy is a bank. Canadian Wealth Creation Centre Inc. calls the long-term aim Infinite Financial Sovereignty®, a registered trademark of Jose Salloum: a family financing more of its own purchases through its own system over time and relying less on outside lenders. It is a goal, never a promise, and no dividend option decides it. The option is one of the settings that serves it.

For tax, a dividend applied to buy additions creates no taxable amount in the year, because paragraph 148(2)(a) of the Income Tax Act excludes from a dividend's deemed proceeds the part applied immediately to pay a premium under the policy. It also leaves your adjusted cost basis where it was: it is not a premium you paid from your own pocket, and it is not proceeds you received. From then on the addition sits inside the policy, governed by the exempt policy rules below rather than by yearly taxation.

Cash: the dividend leaves the policy

The cash option pays the dividend to the owner as money, by cheque or by deposit to an account. It takes this year's dividend out of the policy, and that has two consequences worth seeing clearly.

First, what the policy does not get. Taking this year's dividend in cash gives up the coverage and cash value it could have bought, and the future dividends that addition might have earned. It does not freeze the policy. The guaranteed cash values keep following the schedule printed in your contract, and additions bought in earlier years stay in force and can keep sharing in future dividends under the contract. The death benefit stays at the guaranteed amount plus those earlier additions.

Second, what the tax rules do. A cash dividend is treated as proceeds of a disposition of part of your interest in the policy. It lowers your adjusted cost basis, and only the part above the basis is income that year. While the dividend is smaller than your basis, it produces no income. As the basis shrinks over the years, later cash dividends are more likely to be partly or wholly taxable. The mechanism, with an illustrative example, is in the tax section.

Cash fits a year when the money is needed now and the policy's other purposes are already covered. The question to ask before choosing it is short: what is my adjusted cost basis today, and would this dividend exceed it?

Premium reduction and premium offset

These two are often run together, and they are not the same thing. Premium reduction is an option. Premium offset is an arrangement that relies on future dividends.

Premium reduction

Premium reduction applies the dividend to the premium falling due, so you pay less from your own pocket that year. Where the dividend is smaller than the premium, you pay the difference. Where it is larger, the excess is applied as the contract provides, often as paid-up additions or cash.

Like cash, this dividend buys no new addition. Like cash, it does not freeze the policy: the guaranteed cash value keeps rising on its printed schedule, and additions bought earlier stay in force and can share in future dividends. Unlike cash, it creates no taxable amount, because a dividend applied immediately to a premium under the policy is excluded from deemed proceeds, and it leaves your adjusted cost basis unchanged. One consequence follows: while dividends pay part of the premium, your basis grows only by the premiums you pay yourself.

Premium offset: can premiums come back?

Reduction applies one dividend to one premium. Offset, where the contract offers it, is an arrangement under which future dividends, and under some contracts existing paid-up additions, are expected to cover every future premium. The word expected carries the whole weight, because the scale that makes offset possible is declared one year at a time.

Offset is not paid up. A paid-up policy needs no further premium under its contract. A policy on offset still has a premium due every year, and something has to pay it. If dividends fall short, the contract decides which of these happens, sometimes with an election from you:

1. You resume paying some or all of the premium from your own pocket.
2. The insurer surrenders some existing paid-up additions to cover the shortfall, where the contract allows it.
3. Where neither covers the premium, the contract's provisions for an unpaid premium apply, which can include an automatic premium loan from the insurer if the contract provides one.

A surrender of additions lowers the death benefit and the cash value, and a surrender is a disposition under subsection 148(9) of the Income Tax Act. If the proceeds exceed the adjusted cost basis that applies to the part surrendered, the excess is income that year. So before relying on offset, ask the insurer three things in writing: which amounts it would use if dividends fall short, whether premiums would resume, and how you would be told.

Dividends on deposit: held by the insurer, beside the policy

The deposit option moves the dividend out of the policy and into an account the insurer keeps beside it. The insurer holds the money and credits interest at a rate it sets and may change. The policy's death benefit and cash value do not rise, and the premium is unchanged.

Money on deposit sits with the insurer, but it is not policy cash value. Cash value is a contractual feature of the insurance itself, sits inside the exempt policy, and is what a policy loan is measured against. A deposit balance is a side account: the owner's money, withdrawable on the terms the contract sets, and paid at death as the contract provides, separately from the death benefit. It buys no insurance and earns no dividends of its own. It earns interest.

The tax treatment has two layers. The dividend itself is deemed proceeds when you become entitled to it, on the same footing as a cash dividend, because nothing in paragraph 148(2)(a) of the Income Tax Act treats a dividend held on deposit as applied to a premium. So it lowers your adjusted cost basis and is income only above it. The interest credited afterwards is ordinary interest: 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 it was not included in an earlier year.

That interest is taxable each year whether or not you withdraw it, and whether or not a slip arrives. The Canada Revenue Agency's T5 guide lists interest an insurer paid in connection with an insurance policy among the amounts reported in box 13, and it says a T5 slip need not be prepared when the total paid to one recipient for the year is less than $50 (CRA, T4015 T5 Guide). No slip does not mean no income. The insurer can confirm the amount credited each year, and your accountant confirms how to report it.

This answers a common misunderstanding. Leaving dividends with the insurer is not the same as keeping them inside the policy. The deposit option creates yearly interest income; paid-up additions do not.

Enhanced or term coverage: more death benefit from the dividend

This option uses the dividend to buy a layer of one-year term insurance on top of the base policy or, in an enhanced design, a mix of term 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 additions the design buys.

Names and mechanics vary between insurers, and only the contract wording settles them. In the simplest version the whole dividend buys one-year term coverage. How much it buys depends on the dividend declared and on the term cost at the attained age of the person insured, so the coverage can change every year and can fall as that person ages even if the dividend holds. In an enhanced version the insurer combines a smaller base policy with a term layer and, over time, replaces the term layer with paid-up additions as dividends allow, aiming to hold the total at a stated amount.

Is the enhanced amount guaranteed? It depends on the product. Some Canadian designs guarantee it for life even if future dividends fall short. In others the guarantee is limited or absent, and a shortfall can lower the total death benefit rather than raise the premium. Ask the insurer in writing whether the enhanced amount is guaranteed, for how long, and what happens if dividends fall short.

What about cost? An enhanced design trades part of the guaranteed base coverage for a layer carried by dividends. Whether its required premium is lower for the same initial and guaranteed benefits can only be shown by two matched illustrations from the insurer, one for each design, so ask for both. The trade-off on the other side is cash value: the part of each dividend spent on term coverage buys one year of protection and no cash value.

For tax, the part of the dividend applied to the term premium pays a premium under the policy, so it is kept out of the deemed proceeds and leaves the basis unchanged. How a term layer sits under the exempt rules depends on the insurer's design, and is a question for the insurer. Moving into this option after issue asks the insurer to carry more coverage than it underwrote, so the insurer can ask for evidence of insurability, and can decline.

Using a dividend to reduce a policy loan

Some contracts let a dividend reduce a policy loan; ask whether yours does. Where it is offered and a loan is outstanding, the dividend is applied against the balance the owner owes the insurer.

Who owes whom matters here. A policy loan is an advance from the insurer to the owner, secured by the policy's cash value. The insurer is the lender and receives the interest. The insurer sets the loan rate and may change it. Any unpaid balance, with its interest, is deducted from the death benefit when the person insured dies, and from the cash value if the policy is surrendered. If the loan and interest grow to reach the cash value, the policy can lapse, and a lapse with a loan outstanding can create taxable income.

For tax, paragraph 148(2)(a) of the Income Tax Act excludes from a dividend's deemed proceeds the part applied immediately to repay a policy loan, as the policy's terms provide. So a dividend used this way, under a contract that provides for it, creates no proceeds in the year. How the repayment is then recorded on your adjusted cost basis is a question to put to the insurer, with your accountant, before you rely on it. The loan itself, and what makes it taxable, is covered on policy loans and when a policy loan becomes taxable.

How the Income Tax Act treats each option

The whole treatment rests on one mechanism. A policy dividend is a deemed disposition of part of your interest in the policy; the proceeds are compared with your adjusted cost basis; and only the excess is income.

Paragraph 148(2)(a) of the Income Tax Act provides that where a policyholder becomes entitled to receive a policy dividend, the policyholder is deemed to have disposed of an interest in the policy at that time. The proceeds are 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 additions, premium reduction, the term part of an enhanced design and, where offered, loan reduction produce nil proceeds. Cash and deposit produce proceeds equal to the dividend.

Subsection 148(1) then does the counting. It includes in income the amount, if any, by which the proceeds exceed the adjusted cost basis of that interest immediately before the disposition. Where the basis is larger, nothing is income. Where the proceeds are larger, the excess is income that year, and the insurer reports it.

Element H of the definition of adjusted cost basis in subsection 148(9) is where a cash or deposit dividend lands: it subtracts the proceeds of disposition the policyholder became entitled to receive. The basis also moves for other reasons, and over time they matter more than any single dividend. Among them:

• It rises with the premiums you pay yourself.
• It falls with dividends taken in cash or left on deposit, and with other proceeds, such as a policy loan or a surrender.
• It falls each year by the net cost of pure insurance, an amount the insurer determines under the regulations.
• A dividend applied to a premium neither raises nor lowers it.

On many participating policies the yearly deduction for the net cost of pure insurance makes the basis decline over time, and it can reach zero. That is why a cash dividend that produced no income in an early year can be partly or wholly income in a later one.

Illustrative example. This is arithmetic, not an illustration of any contract. Assume no other change to the basis during the year, and that the year's deduction for the net cost of pure insurance has already been made when the dividend is declared.

The second row is the one that surprises people: the first $900 of the dividend brings the basis down to zero, and the remaining $100 is income that year. The insurer keeps the running figure and can give you your current basis on request. An accountant confirms what any year's slip means on your return and, if you live in Quebec, on your Quebec return as well.

What the options do to the exempt status

Any option that buys paid-up additions, including an enhanced option while it is buying additions, adds value inside the policy that the exempt test measures. Cash, premium reduction and deposit put no new value inside the policy. The test itself is in section 306 of the Income Tax Regulations.

In substance, section 306 treats a policy as exempt at a given time if its accumulating fund, determined without regard to any policy loan, does not exceed the total of the accumulating funds of the exemption test policies the regulation describes for it. While 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. For a participating policy, the regulation directs 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 test looks at the whole policy, and changes in coverage or death benefit can matter as well. The exempt test is explained in the glossary, and what happens when a contract fails it has its own page.

Keep two things apart. The dividend option is one factor; extra deposits you choose to make on top of the premium are another, with an effect of their own, and an extra deposit can add far more to the policy in a single year than a dividend does. The insurer tests the policy on each anniversary and acts under the contract's terms. Its adjustments can include increasing the death benefit, applying a dividend differently that year, holding back an amount or, if the wording allows nothing else, paying an amount out.

Before maximizing additions or deposits, ask the insurer three questions in writing. How does this contract prevent a failed exempt test? May the insurer change the coverage or pay an amount out? And how will you be told?

Switching options: what can and cannot be undone

Your contract sets whether, when and how you can change the option, and the consequences depend on the direction of the change. Some contracts restrict changes to the policy anniversary. Some limit the options available in the early years or during an enhanced period. Leaving an enhanced option can end the coverage it was carrying, and possibly its guarantee. Moving back into additions, or into a term or enhanced option, may need evidence of insurability on some contracts, because it asks the insurer to carry more coverage. On some contracts extra deposits are allowed only while dividends buy additions, so leaving that option can end the right to deposit.

One thing no switch can do is reach back in time. The additions that past dividends could have bought are not bought retroactively when you switch later; the policy moves forward from the day the new election takes effect. A policy that has been on paid-up additions and then changes keeps the additions it already has.

Check which option your contract uses today, and whether it still matches why you own the policy. The option chosen at issue shapes the contract until you change it, so ask what a change would do before you make it. Before any switch, ask the insurer in writing:

• Which options does my contract allow now, and from when?
• What happens to any guarantee, including an enhanced guarantee, if I switch?
• Will I keep the right to make extra deposits?
• Does the switch need evidence of insurability?
• What will the death benefit and cash value look like, guaranteed and illustrated, under the new option?
• On what date does the change take effect?

Which option fits which purpose

No single option suits everyone, and what follows is not a ranking. The right election follows from why you own the policy and what you need from it this year.

Some choices work against their own goal. A person who wants growth inside the policy and chooses the deposit option has put the money beside it. A person who wants to know what next year's dividend will be is asking a question only the insurer's board answers, one year at a time. And no option pays a dividend out to you, in cash or on deposit, without the adjusted cost basis moving, because element H of the definition in subsection 148(9) subtracts it.

The author is paid by commission from an insurer when a policy is issued, which is disclosed at the foot of every page. That interest is one more reason to decide from your purpose, with the contract in front of you.

If you need money or cannot keep paying

A dividend option is not a way to borrow, and borrowing is not a dividend option. When money is needed, or premiums become hard to pay, these are the usual routes, and each works differently.

Two cautions belong with this table. First, the dividend scale interest rate an insurer publishes is not your policy's return, and the insurer's loan rate can be higher than it; ask for the current loan rate in writing and for how it can change. Second, if the money is meant for a relative, there are two separate debts. The owner borrows from the insurer or from a lender, then makes a separate loan to the relative, documented on its own: who lends, who borrows, the interest if any, the repayment schedule, what happens on default and what happens to the balance at death. Private family capital walks through that structure, and a policy advance and other credit compares the loan routes. The paragraph 60(s) deduction applies only to a repayment of a policy loan that was previously included in income, and only up to that amount.

Surplus is not need: before any option matters

A dividend option only matters once someone owns a participating policy. If you are weighing a purchase because you have money left over each year, the surplus answers fewer questions than it seems to. It does not show that you need permanent insurance. It does not show that you can pass underwriting. It does not show that the premium would survive a bad year. And it does not settle how much should go to the required base premium against optional extra deposits, which carry different commitments and different effects on the exempt test.

The fair case against buying deserves to be said plainly. In the early years the cash value can be well below the premiums paid, and your illustration shows that gap year by year. Dividends are not guaranteed. The insurer's loan rate can exceed the dividend scale interest rate. And money you may need in the first years may be better kept liquid. Participating whole life is life insurance, not an investment, and a dividend option is a feature of a contract rather than a reason to own one. Why a policy is not an investment takes that question further.

Other tools do other jobs, and they are listed here in no order:

• Paying down costly debt reduces an interest cost you already know.
• A liquid reserve covers near-term needs without any contract.
• Term insurance covers a death-benefit need for a set period; see term insurance.
• Non-participating whole life fits if a guaranteed permanent benefit, rather than dividends, is the need; see participating and non-participating whole life.

Registered plans such as a TFSA, an RRSP or an FHSA are savings plans, not insurance. Canadian Wealth Creation Centre Inc. is licensed for insurance only, so it does not compare them with a policy; that question belongs with a professional registered to advise on them.

Who answers which question:

Request an illustration you can compare

An illustration shows guaranteed values beside illustrated values that assume the current dividend scale continues. Only the guaranteed columns are guaranteed. To see what each option would do to your policy, ask the insurer, through your representative, for matched illustrations: the same person insured and the same funding, run under each option the contract allows, at the current scale and at a lower scale where the insurer provides one. Fill in each cell from the insurer's documents; the blank below shows what to ask for.

For the deposit option, also ask for the interest rate currently credited on deposits and how the insurer can change it.

Choosing an option is a small administrative act with long consequences. Read the dividend option provision in your contract, compare matched illustrations, and put your questions to the insurer in writing. The answers, more than the name of the option, tell you what your policy will do.