Texas General Lines — Life, Accident, Health and HMOLife InsuranceHard
A life insurance policyowner has chosen the 'Accumulation at Interest' dividend option. Which statement accurately describes the taxation of these dividends?
- AThe dividends are not taxable, but the interest earned on them is taxable as ordinary income.
- BBoth the dividends and the interest earned on them are tax-free.
- CThe dividends themselves are taxable as ordinary income.
- DThe dividends are taxed as capital gains, and the interest is tax-free.
Show answer & explanationAnswer & explanation
Correct answer: A. The dividends are not taxable, but the interest earned on them is taxable as ordinary income.
Life insurance dividends are generally considered a return of unearned premium and are therefore not taxable. However, if the policyowner chooses to leave these dividends with the insurer to accumulate interest, the interest earned on those dividends IS taxable as ordinary income in the year it is credited, whether or not it is withdrawn.
Why the other options are wrong
- B. This is incorrect; while dividends are tax-free, the interest earned on them is taxable.
- C. This is incorrect; dividends themselves are generally not taxable as they are considered a return of premium.
- D. This is incorrect; dividends are not taxed as capital gains, and the interest is not tax-free.
Dividend Option: Accumulation at Interest Taxation
When life insurance dividends are left with the insurer to accumulate interest, the dividends themselves are non-taxable, but the interest earned on them is taxable as ordinary income.
- Dividends: non-taxable (return of premium).
- Interest on dividends: taxable as ordinary income.
- Interest is taxed in the year credited.
Memory trick: Dividends are free, but interest you'll see (taxed).