The word dividend does a lot of damage here. People hear it and picture a stock dividend, a slice of company profits mailed to stockholders. 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 with room to spare. It assumed more deaths, higher costs, and lower investment returns than it really expects. When the real numbers come in better than the pricing assumed, a participating carrier hands part of the difference back to owners. You overpaid on purpose, and the refund of that overpayment is the dividend. That's why dividends usually aren't taxed as income, as long as 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 people died than the pricing assumed. Expenses: running the company cost less than assumed. And investment earnings: the general account earned more than the rate guaranteed in your policy. That account is a huge, careful pile of mostly long-term bonds. Each year the carrier measures real results against its assumptions in all three columns. Then it declares a dividend scale out of 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.