Dividends – Not Just A Return Of Premium
“The dividend is just a refund of excess premium. They overcharged you and they’re giving you your money back” – Typical Financial Entertainer
Yes, the it is categorized – properly – as a return of premium by the IRS. But the dividend is not just a return of premium. It is not less than that. But it is much more than that.
To understand why it is more we must stop thinking like we are merely a customer. It is simply not analogous to going to McDonalds, giving a $20 bill for your Big Mac and being handed your change back, as the entertainers like to imply.
Remember the characteristics of the company selection that Nelson Nash mentions in the introduction – right on page 1. We want to do business with Mutually owned companies that have been around and paid dividends for over 100 years. My favorite company just made it’s 120th consecutive dividend payment.
The mutually owned company is an amazing corporate structure, if you’d like to learn more about it read The Perfect Investment by Carlos Lara or these four articles (1, 2, 3, 4) from the Lara-Murphy Report or pick up a copy of The Perfect Investment, by Carlos Lara.
As a summary, most businesses involve two distinct groups in their operations. The company and the customer. The customer is the profit center, and the business seeks to satisfy customer demands. The better they meet customer demands, the more profit the company makes, which properly managed allows for growth and expansion of the company and increased wealth for the owners and employees.
In publicly traded companies, the owners include the shareholders. When the companies do well, a portion of the profit, called the divisible surplus, is divided among the owners and shareholders in proportion to their equity in the company. This is called the dividend.
Co-operative companies, or mutually owned companies are different. With an electric cooperative, for example, the businesses and residents who receive their electricity from the electric cooperative, are also owners of the cooperative. By virtue of being customers, they have voting rights in the operation of the company. When the company profits, surplus is required by law to be returned to the customers/owners.
In the insurance sector, the customers are the policy holders. With a mutual insurance company, the policy holders are the owners.
The financial objective of stock insurance companies is to generate wealth for the shareholders. Policy holders are mere customers and profit centers. They only benefit from the product they purchase.
For Mutual Insurance Companies, the financial objective is to do what is in the best interest for their policyholders. The policyholders benefit from the product they purchased and again benefit when the company is profitable (which their purchase contributes to), sharing in that profit.
Why is this uniquely beneficial for becoming your own banker? To demonstrate this, Nelson selected the grocery store for his example part 2 (page 15). He needed the reader to consider a business that everyone patronizes. You are going to buy groceries. If you owned an Albertsons, would you ever go to a Kroger for your milk and eggs?
In his example, the grocery store is analogous to the bank. Just as we are going to buy groceries, it can’t be escaped, we finance everything we buy. It is unavoidable that the process of banking will be involved. As my mentor James Neathery says, “Banking Is”.
Most of us cannot afford to start our own grocery store. But we can become our own banker.
In practicing IBC, we are starting our own banking system with the Mutually Owned Life Insurance Company as our business partner. They are your hired help providing all the accounting, secretarial, marketing, product development, legal, and all the other necessary business functions while we, the policy owners, provide the capital investment. When they are profitable, we are profitable. When we are profitable, they are profitable.
Is the dividend a return of premium? Yes, it is. But if that is all it was, cumulative dividends would never exceed cumulative premium. But cumulative dividends will exceed cumulative premium. By a substantial amount.
Dividends are a return of premium AND your share in the profitability of the company you own!
Another topic that comes up with regard to dividends and IBC is the issue of Direct Recognition and Non-Direct Recognition policies.
Direct Recognition means that the company recognizes that you have taken a policy loan and the dividend they pay is reduced in proportion to the outstanding loan balance.
Non-Direct Recognition means that the company does not reduce the dividend due to an outstanding loan balance. The company is obviously tracking the money you have borrowed from them, with your death benefit serving as collateral, but when dividend payments are calculated the loan balance is not considered. You get the same dividend whether you have loans equal to 80% of your cash value or have no loan at all.
Most companies offer one or the other, while a few insurance companies have provisions or riders that allow a one-time change from direct recognition to non-direct.
Non-Direct recognition policies will be accompanied by variable loan interest rates. Direct recognition policies will have fixed interest rates. This makes perfect sense.
Insurance companies have huge amounts of capital. They receive the premiums paid by policyholders and invest the money in such a way as to be able to pay the 3% of term insurance death benefits that they might have to pay, and the 100% of whole life policies that they will have to pay.
Policy owners have a contractual right to borrow the company’s capital – they are first in line. Unlike loans from your commercial bank, these loans are not inflationary. Taking the loan means the insurer cannot use those dollars in other investments. If the insurer expects 5% on their investments and they loan it to policy owners at 3% then that reduces profitability and therefore dividend.
But if the insurer is expecting to make 5% and charges 5% then the loan is revenue-neutral and does not affect profitability. If the loan is 6% then it represents increased profit. That profit is then returned to the policy holders in the form of a dividend.
For the purposes of Infinite Banking, non-direct recognition is preferrable. Consider the illustrations in the Equipment Financing section of BYOB (page 51-63). The amount of loans that could be taken as passive income would be reduced if the dividend was reduced.
Yes, with a lower interest rate the loan balance would grow at a slower rate. But what does the dividend do? It doesn’t just mathematically negate some…or all…of the interest paid on the loan. It also purchases more death benefit. That cash value must continue to grow to equal at age 121. Higher future value means a higher present value.
Another dividend related topic I’ll discuss here is dividend rates. A sales tactic often used by agents using IBC as a marketing tool is to compare dividend rates. Company A declared a dividend rate of 5% while Company B declared a dividend rate of 4.75%. Therefore, Company A is better. Such a comparison is invalid and meaningless.
It is also often misunderstood that the declared rate is analogous to an interest rate on your savings account. The assumption is that if you have $100,000 in cash value and a 5% dividend rate is declared, you’ll get a $5,000 dividend. Or that you can add the guaranteed rate of 1.5% to the dividend rate of 5.0% and say that your policy made 6.5% internal rate of return that year. But that is just not how it works.
The dividend rates that are published are gross rates. That means it does not include any business expenses or overhead – the mortality charge and expense charge. These additional expenses can make a 5% declared rate pay a smaller dividend by volume than a 4.75% declared rate.
The last thing to discuss regarding dividends is how they can be used. I’ll have a separate article on PUA riders and how they vary across companies and products. For now, I’ll just mention the four options available for dividend use:
- Purchase Paid-Up Additions – purchase additional fully paid-up death benefit.
- Premium Offset – reduce or even eliminate premium.
- Loan repayment – premium goes directly to reduce the outstanding loan balance.
- Receive in cash – a check for the dividend value is mailed to you to spend as you please.
With each of the first 3 options, the dividend is not taxed. This is because the money is never received. It is an internal transaction within the insurance company. In purchasing PUAs the money is not received and instead buys additional insurance.
In options 2 and 3 multiple obligations exist. On the policy owners’ side, they either owe a premium payment or a loan payment. The insurer owes a dividend. The two parties simply agree to reduce or eliminate the obligation. There is no income for the policy owner.
And yes, as discussed, the dividend is a return of premium – as the financial entertainers like to fixate on. Would you be taxed on the change you received for your Big Mac purchase?
Dividends, as received on stocks in your retirement plans, that are reinvested are also not taxed when received. Instead, the taxes will be levied during the distribution phase – taxing the harvest instead of the seed.
Even in the fourth option, receiving in cash, the dividend is not taxed unless and until the cumulative dividend distribution exceeds the cumulative premium paid (MEC status not withstanding).
Becoming Your Own Banker is about controlling the banking function in your life. These four options give the IBC practitioner enormous amounts of control over their capital. Our first choice should always be to have the dividend purchase more Paid-Up Additions. But life has a way of throwing curveballs, and the banker can do what he wants to meet his needs.
Remember, the Infinite Banking Concept is a process. It is a concept, not a product. But there is an ideal platform for practicing Becoming Your Own Banker – and that is a Whole Life insurance policy with a Mutually Owned company that has paid dividends for over 100 years.
I hope this primer on dividends cleared up some misconceptions and misinformation that exists out there, so that you can know what is going on. And when you know what is going on, you’ll know what to do.
Semper Reformanda
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