PSI Life Exam Practice Test

Why are dividends from insurance policies generally not subject to taxation?

1. They are considered income

2. They can only be collected after a claim

3. Paying dividends returns a premium

4. They are classified as investment returns

The correct answer is: Paying dividends returns a premium

Dividends from insurance policies are generally not subject to taxation because they are considered a return of premium rather than taxable income. When policyholders receive dividends, they are essentially getting back part of the money they paid into the insurance company. This return of premium does not count as income, which is typically subject to taxation. The concept of dividends in this context refers to the surplus earnings that an insurance company can distribute to policyholders based on their participation in the company’s financial performance. Since these dividends represent a reimbursement of the original premiums paid, rather than earnings on investment or interest income, they enjoy tax-exempt status. The other choices do not accurately capture the reason behind the tax exclusion for dividends. For instance, dividends are not classified strictly as income and also are not obtained solely after a claim is made. They are related to the overall performance of the insurance policy rather than being strictly tied to claims. Additionally, while investment returns are taxable, dividends from insurance policies are distinct in that they do not fit into that category.