3.4 Nonforfeiture & Dividend Options

Nonforfeiture Options

Nonforfeiture options protect the cash value an owner has built in a permanent policy if they stop paying premiums. State law requires every permanent policy to offer the same three:

• Cash surrender: the owner receives the net cash surrender value and the policy terminates. Any amount above the owner's cost basis (premiums paid) is a taxable gain.

• Reduced paid-up insurance: the existing cash value is applied as a single premium to buy a smaller, fully paid-up permanent policy that lasts for life with no further premiums.

• Extended term insurance: the cash value buys term insurance equal to the original face amount for as long a period as the cash value will fund. This is the automatic default if the owner stops paying and makes no election.

Worked Election: Reduced Paid-Up vs. Extended Term

Suppose a 45-year-old owns a $100,000 whole life policy with $18,000 of cash value and stops paying. Under reduced paid-up, that $18,000 is used as a single net premium at the attained age; because a single premium at 45 buys only a fraction of full coverage, it might purchase a $40,000 paid-up policy that lasts for life with no further premiums.

Under extended term, the same $18,000 instead buys term insurance at the full $100,000 face, but only for a limited stretch - perhaps 14 years and a few months. So the trade is direction-based: reduced paid-up keeps a smaller benefit permanently, while extended term keeps the full benefit temporarily. Both figures come straight from the policy's guaranteed nonforfeiture table.

Trap: Reduced paid-up cuts the face amount but keeps permanent coverage; extended term keeps the full face but only for a limited time. Remember the CRE mnemonic: Cash, Reduced paid-up, Extended term.

Participating Policies & Dividends

A participating (par) policy - typically a whole life policy from a mutual insurer - may pay policy dividends. Legally, a dividend is a return of overcharged premium: the insurer charged a conservative premium and refunds the surplus. Because it is a return of the owner's own money, a dividend is not taxable income. Dividends are never guaranteed; they depend on the insurer's mortality, expense, and investment experience.

The Dividend Options

1. Cash: the dividend is paid directly to the owner by check.

2. Reduce premium: the dividend is applied toward the next premium due, lowering out-of-pocket cost.

3. Accumulate at interest: the insurer holds the dividends and pays interest. The dividend stays tax-free, but the interest earned is taxable in the year credited.

4. Paid-up additions: dividends buy small amounts of fully paid-up additional permanent insurance at the insured's attained age - no underwriting required. This raises both death benefit and cash value and is generally the most efficient option.

5. One-year term (fifth dividend option): the dividend buys one year of term insurance, often equal to the policy's cash value, adding temporary death benefit.

Comparing Cash vs. Paid-Up Additions

Imagine a $400 annual dividend. Taken as cash, the owner pockets $400 each year but the death benefit and cash value do not grow from it. Directed to paid-up additions, that same $400 buys a slice of fully paid-up permanent insurance at attained age with no underwriting; over many years these slices compound, materially raising both the death benefit and cash value with no annual tax drag. Cash suits an owner who needs money now; paid-up additions suit long-term growth.

Taxation Of Dividends

Because dividends are a return of premium, the dividend itself is not taxed. The key exception the exam tests: under the accumulate-at-interest option, the interest the insurer pays on the held dividends is taxable income, reported annually even if left on deposit.

• Dividend (return of premium): not taxable

• Interest on accumulated dividends: taxable

• Paid-up additions: increase cash value with no current tax until surrendered

Putting It Together

Nonforfeiture options answer "what happens to my cash value if I stop paying?" Dividend options answer "what do I do with surplus the insurer returns while the policy is in force?" Keep them separate: nonforfeiture is a lapse/surrender mechanic on permanent policies; dividends apply only to participating policies that are still active.

Choosing A Nonforfeiture Option

• The owner wants cash now and no longer needs coverage -> cash surrender (watch for taxable gain above basis).

• The owner wants permanent coverage with no more premiums but accepts a smaller benefit -> reduced paid-up.

• The owner wants the full original face amount for a while, perhaps a temporary need -> extended term (also the default).

Dividend Option Snapshot

Trap: "Paid-up additions" (a dividend option that buys more permanent coverage) is different from "reduced paid-up" (a nonforfeiture option that shrinks the policy). Same word "paid-up," opposite direction - one adds coverage, the other reduces it.