Regarding life insurance dividends, which statement is true?

• A. Dividends are always taxable as ordinary income
• B. Dividends may be taxable if they exceed the cost basis
• C. Dividends are never taxable
• D. Dividends are taxed as capital gains

Answer: (B)

Dividends from a participating life insurance policy are treated mainly as a return of the money you’ve paid into the policy. They’re not taxed as income up to the amount you’ve invested (your cost basis). If you take dividends in cash and the total amounts you’ve received exceed your cost basis, the excess is taxable as ordinary income in the year you receive it. Growth or dividends left inside the policy grow tax-deferred, but when you eventually take a distribution that exceeds your cost basis, that excess is taxed as ordinary income rather than as capital gains. The dividends themselves aren’t automatically taxed as capital gains, and they aren’t always taxable—only the portion over your basis is.