If personal life insurance dividends are kept in the policy to earn interest, how is the interest treated for tax purposes?

• A. Interest is tax-deferred
• B. Interest is taxable
• C. Dividends become tax-free
• D. The policy becomes tax-deductible

Answer: (B)

When dividends from a personal life insurance policy are left with the insurer to earn interest, the tax treatment applies to the interest earned, not to the dividends themselves. The dividends are typically a return of premiums and are not taxed up to the total premiums paid. The interest that accrues on those accumulated dividends, however, is taxable as ordinary income in the year the interest is credited to the policy. The policy’s cash value growth remains tax-deferred, but the interest on accumulated dividends is a current-year taxable event.