Taxation✓ Verified · outline & fact-checked · Sep 2026Difficulty 1/5
Dividends paid on a participating life insurance policy are, for federal income tax purposes:
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Answer & full 3-part explanation (select an option above, or peek)
Why C is correct
Dividends on a participating life insurance policy are not true dividends from corporate earnings; they are a return of premiums that were overcharged. Because they are a return of the policyowner's own money, they are generally not taxable as income under IRC §72. The dividends reduce the policyowner's cost basis in the policy until the basis is fully recovered. After the basis is fully recovered, dividends may become taxable. Interest credited on dividends left to accumulate with the insurer is taxable as ordinary income.
Why the other options are wrong
- A) Policy dividends are a return of premium, not investment income, so they are not taxed as ordinary income when received by the policyowner. The owner's own money is coming back.
- B) Dividends are not capital gain; they are a return of the owner's own premium dollars and instead reduce the cost basis of the policy. Basis reduction is the correct result.
- D) Reinvestment in paid-up additions does not make the dividend taxable; the return-of-premium treatment applies regardless of the dividend option selected. Every option keeps the dividend nontaxable. The choice does not matter for tax.
Memory hook
A policy dividend is your own overpaid premium coming home — not income.