South Carolina Life Insurance Practice Exam

Why are dividends in life insurance policies generally not taxable?

1. They are considered gifts

2. They are a return of unused premiums

3. They are tax-exempt by law

4. They are not reported as income

The correct answer is: They are a return of unused premiums

Dividends in life insurance policies are generally considered a return of unused premiums. This means that when an insurance company pays out dividends to policyholders, it is essentially giving back a portion of the premiums that were overpaid or not fully utilized based on the insurer's actual costs and profits for that year. Because these dividends represent a return on the premiums paid rather than income generated, they are not subject to income tax. This tax treatment reflects the principle that individuals should not be taxed on money that is merely being returned to them after having previously paid it. Furthermore, dividends do not represent profit but rather a sharing of surplus by the insurance company, which is another reason they are categorized this way for tax purposes. In summary, since dividends reflect a return of excess premium payments rather than additional income, they remain non-taxable to the policyholder.