The word dividend does a lot of damage here, because everyone hears it and pictures a stock dividend, a share of corporate profits mailed to shareholders. A whole life dividend is a different animal, and the difference explains both where it comes from and how the IRS treats it.
Legally, a whole life dividend is classified as a return of premium. The carrier priced your policy conservatively, on cautious assumptions about deaths, expenses, and investment returns. When reality comes in better than the pricing assumed, a participating carrier returns part of the difference to policyholders. You overpaid on purpose, and the refund of that overpayment is the dividend. That's why dividends generally aren't taxed as income while your total dividends stay under what you've paid in. The IRS sees money coming back to you, not money earned.
The refund is calculated from three sources. Mortality: fewer insured people died than the pricing assumed. Expenses: running the company cost less than assumed. And investment earnings: the carrier's general account, that huge conservative portfolio of mostly long-term bonds, earned more than the guaranteed rate baked into your policy. Each year the carrier tallies actual experience against assumptions in all three columns and declares a dividend scale from the surplus. That's also why dividend rates drift up and down over decades. They track the carrier's real experience, especially the slow turnover of that bond portfolio.
Understand the source and the standard caveat stops being fine print and starts being obvious: dividends aren't guaranteed. They can't be, because they're a refund of surplus that has to exist first. A carrier's century-long habit of paying them tells you about its management and its book of business, and it still isn't a promise.
What you do with a dividend once it's declared is its own decision, and the four dividend options walks through it. But knowing what the money is changes how you read every illustration that projects it.