Participating Policy Dividends
Dividends on participating (par) whole life policies are returns of overpaid premium — not investment returns. The insured has five options for what to do with them:
| Dividend Option | What Happens | Effect on Death Benefit |
|---|---|---|
| Cash | Dividend paid out in cash | No change |
| Reduce Premium | Dividend applied to next premium due | No change |
| Accumulate at Interest | Dividends left with insurer, earn interest | No change (but interest is taxable) |
| Paid-Up Additions (PUAs) | Dividend buys additional paid-up whole life coverage | Increases — most popular option for building DB |
| One-Year Term | Dividend buys additional one-year term insurance | Temporarily increases DB |
Exam Tip: Paid-Up Additions is considered the most powerful dividend option — it permanently increases both the death benefit and the cash value, and the additional coverage itself is also a participating policy.
Key Policy Riders
Waiver of Premium
- If insured becomes totally disabled, the insurance company waives future premium payments.
- Policy remains in force as if premiums were paid.
- Usually requires a 6-month elimination (waiting) period before premiums are waived.
- Waived premiums are NOT income to the insured.
Accidental Death Benefit (Double Indemnity)
- Pays an additional amount (often equal to face value) if death is caused by an accident.
- "Double indemnity" = 2x face value paid if accidental death.
- Exam trap: suicide, war, aviation (non-commercial), and drug overdose typically excluded.
Guaranteed Insurability Rider (GIR)
- Allows insured to purchase additional coverage at specified future dates without evidence of insurability (no new medical exam).
- Valuable for young, healthy insureds who expect insurance needs to grow.
- Must be exercised on option dates — "use it or lose it."
Payor Benefit Rider (Juvenile Policies)
- On juvenile policies, if the premium-paying parent dies or becomes disabled before the child reaches a specified age, premiums are waived.
- The child's policy remains in force.
Policy Loans — Tax Treatment
- Loans against CSV are not taxable events — no income recognized when the loan is taken.
- No repayment schedule required — interest accrues and is added to the loan balance.
- Outstanding loans reduce the death benefit dollar-for-dollar.
- Trap: If the policy lapses or is surrendered with an outstanding loan, the loan amount (to the extent it exceeds basis) becomes taxable ordinary income in the year of lapse.
1035 Exchanges — Tax-Free Transfers
IRC Section 1035 allows tax-free exchanges between certain insurance/annuity products:
| From | To | Allowed? |
|---|---|---|
| Life Insurance | Life Insurance | Yes |
| Life Insurance | Annuity | Yes |
| Life Insurance | Long-Term Care Insurance | Yes (post-PPA) |
| Annuity | Annuity | Yes |
| Annuity | Life Insurance | NO |
| Endowment | Life Insurance or Annuity | Yes (limited) |
Memory Trick: You can trade DOWN in permanence (life insurance → annuity = less coverage) but not UP (annuity → life insurance would require new underwriting and adds coverage you didn't earn). "Downgrade OK, upgrade NO."
MEC — Modified Endowment Contract
- A life insurance policy fails the 7-pay test if cumulative premiums paid in the first 7 years exceed what would be needed to pay the policy up in 7 level annual payments.
- Once classified as a MEC, it cannot be "un-MECed."
- Tax treatment of MEC distributions: LIFO — earnings come out first (taxable), basis comes out last (not taxable). Opposite of regular life insurance CSV distributions.
- Distributions before age 59½ from a MEC are subject to a 10% penalty (same as IRAs).
- Policy loans from a MEC are also treated as distributions — taxable to the extent of gain.
Exam Tip: The key MEC trap is policy loans. With regular whole life, loans are tax-free. With a MEC, loans are treated as distributions and taxed LIFO (gain first). Always check if a policy is a MEC before recommending a loan.