Texas Life Agent Practice Exam

In a participating Life insurance policy, what are the tax implications for interest and dividends received?

1. Both interest and dividends are taxable

2. Interest is taxable, dividends are not

3. Both are tax-exempt

4. Dividends are taxable, interest is not

The correct answer is: Interest is taxable, dividends are not

In a participating life insurance policy, the tax implications for interest and dividends are distinct. When an insurance policyholder receives dividends, these are generally considered a return of premium and therefore are not taxable, as long as the total dividends do not exceed the amount of premiums paid into the policy. However, any interest earned on these dividends while they remain with the insurance company or are left to accumulate is subject to income tax. Thus, the correct understanding is that while the dividends themselves are typically not taxable, any interest accrued on those dividends is taxable upon receipt. This reflects the broader tax treatment applicable to policy dividends and earned interest, where one component can be non-taxable while the other is taxable.