Rhode Island Life Insurance Practice Exam

How is accumulated interest earned on dividends from an insurance policy taxed?

1. As capital gains

2. As ordinary income

3. As investment income

4. Not taxed at all

The correct answer is: As ordinary income

Accumulated interest earned on dividends from an insurance policy is taxed as ordinary income. This taxation applies because the interest generated is considered taxable income in the year it is received or credited to the policyholder. Unlike capital gains, which are associated with the sale of assets and are usually taxed at a different rate, the interest from dividends does not fall into that category. In most cases, policy dividends themselves are not taxable when they are received, as they are considered a return of premium. However, any interest that accumulates on those dividends while they are left with the insurance company is treated as income. The Internal Revenue Service (IRS) classifies this interest in the same way it classifies interest from savings accounts or other interest-earning assets, hence the classification as ordinary income. This taxation reflects the general principle that income, regardless of its source, must be reported and taxed accordingly.