One of the things I really enjoy about life insurance is the idea that you can earn dividends with the policy, assuming you purchase the right type of policy.

Dividends in a whole life insurance policy are designed to enhance the base policy contract. Life insurance companies issue these whole life policies as a way to share part of the profits of the company with the policyholders. Dividends represent a return of premium, and eventually will represent investment interest that the company earns.

Dividends are allocated in one of four ways. When you invest in a dividend-paying whole life policy, you should understand how these dividend payments work and what you can do with them.

Paid Up Additional Insurance

The most common use of dividends, I think, is the paid up additional insurance option. Paid up additions represent additional insurance that you purchase with the dividends you accumulate from the insurance company. This is an option which many insurers just set as the default option for their whole life policies.

I think this is generally a good idea for a few reasons. First, the additional paid up life insurance gives you additional life insurance protection for no additional out of pocket cost. The "paid up" part of that means that no further premiums are required to keep the policy's additional insurance in force. That's good, because you're probably already paying a lot in premiums for a whole life policy.

Second, the additional paid up insurance means that you're earning additional cash value on the death benefit purchased with the dividends. This only enhances the amount of money you ultimately get from this policy.

What's nice about paid up additional insurance is that it can be cashed in whenever you want. As long as you don't exceed your cost basis in the policy, there's no tax on the withdrawal. Your tax basis is equal to the total amount of premium you've paid into the policy so far.

Paid As Cash

Life insurance companies may pay dividends as cash. Dividend payments paid out as cash are just like any other dividend payment. You take the cash and use it for whatever you want. I don't like this option quite as much, since it does nothing to grow the cash value in the policy. However, the dividends are tax free as long as they do not exceed your premium payments.

Taking dividends as cash does allow you to use the money for other investment purposes. This would be ideal if you had an investment in mind that you wanted to allocate some cash towards.

Accumulate At Interest

You may allow your dividends to accumulate at interest with the insurance company. Accumulating dividends with the insurance company means that you aren't receiving any additional paid up insurance. Instead, the dividends just sit with the insurer. What do they do with this money?

They invest it into their general account. The general account is comprised of bonds and other bond-like investments. These bond investments pay a fixed rate of return. While this isn't necessarily a high rate of return, it's better than nothing.You can expect the returns to mirror what you would receive in a high yield savings account.

Reduce The Premium Payment

Reducing the premium payment with dividends is the oldest life insurance policy trick in the book. This is sometimes called "accelerated pay" in the industry. Dividends are paid, but instead of taking the payment or using it to buy more life insurance death benefit, you simply direct it towards the premium payment.

If the dividend is at least equal to the premium payment, then the policy is considered "self-completing."The policy is not paid up, however. Dividends are never guaranteed. So, if the dividends are reduced in future years, guess what? You may be responsible for picking up those premium payments again. This could be inconvenient when you're old and grey and don't want to pay for life insurance anymore.

Incidentally, there was a problem with life insurance agents and something called "vanishing premiums" many years ago. The idea that dividends could be used to eliminate the need to pay life insurance premiums was a major selling strategy in the industry. Unfortunately, dividend scales of life insurers were reduced after agents told their clients that they would never have another premium payment due. Clients got angry. Lawsuits were filed. It was a mess.

If you use this strategy, just understand that your premiums are only paid if the dividend is sufficient to cover the premium payment. Otherwise, you should be able to afford that premium payment at any time in the future until the policy is actually paid in full.