West Virginia State Life Insurance Practice Exam

Which of the following statements about accumulated interest earned on dividends from an insurance policy is TRUE?

1. It is tax-free

2. It is taxed as capital gains

3. It is taxed as ordinary income

4. It is subject to estate tax

The correct answer is: It is taxed as ordinary income

The correct answer indicates that accumulated interest earned on dividends from an insurance policy is taxed as ordinary income. This means that if an insurance policyholder receives dividends and those dividends earn interest, the interest component is recognized as income and is subject to federal income tax. This treatment follows the general tax principles applied to most forms of interest income, where interest is included in the taxpayer's taxable income for the year it is received or credited. The IRS does not classify this interest as capital gains, which typically pertains to profits from the sale of assets rather than interest earnings. Moreover, this income is not subject to estate tax, as estate tax deals with the total value of a deceased person’s estate, rather than individual income sources that may be earned prior to death. Understanding this classification is important for policyholders, as it impacts their tax liabilities and financial planning related to insurance products.