Understanding the tax implications on the interest earned from dividends left on deposit with an insurance company, particularly within the framework of participating life insurance policies, is crucial for tax planning and financial management.
Overview
Interest earned on dividends from participating life insurance policies left on deposit with the insurance company is subject to taxation. This interest is treated as ordinary income and must be reported on tax returns. The policyholder must understand how this impacts their overall tax situation.
Participating Life Insurance Policies
Definition
Participating life insurance policies are those in which policyholders are entitled to share in the insurer’s profits. These profits are typically distributed as dividends, which can be taken in cash, used to reduce premiums, or left on deposit with the insurer to earn interest.
Tax Implications
Dividends
Dividends received from a participating life insurance policy are generally not taxable because they are considered a return of premium paid. However, any interest earned on the dividends left on deposit with the insurance company is taxable.
Interest Earned
Definition
When dividends are left on deposit with the insurance company instead of being received in cash, they earn interest over time. This interest is considered ordinary income and is subject to federal income tax.
Tax Treatment
- Reporting: The insurance company reports the interest earned on Form 1099-INT, which the policyholder must include in their tax return.
- Tax Rates: The interest is taxed at the policyholder’s marginal tax rate.
- Timing: Taxes are due for the tax year in which the interest is credited to the policyholder’s account.
Comparisons and Related Terms
Capital Gains vs. Ordinary Income
Interest on dividends is taxed as ordinary income, not as capital gains, even though the principal (dividends) might be derived from investments subject to capital gains taxation.
Non-Participating Policies
Interest earned on dividends from non-participating life insurance policies follows a similar tax treatment. The focus is on the interest earned rather than the dividends themselves.
FAQs
Is the principle amount of dividends taxable?
How do I report the interest earned to the IRS?
Are there any exceptions to this tax rule?
References
- IRS Publication 550: Investment Income and Expenses
- Internal Revenue Code (IRC) Section 101 – Life Insurance policies
- FINRA: Participating vs. Non-Participating Policies
Summary
Taxation on interest earned from dividends left on deposit with an insurance company, within participating life insurance policies, requires careful reporting and understanding of marginal tax rates. While dividends themselves are typically non-taxable, the interest accrued on these amounts must be included as ordinary income on your tax return.
By fully grasping these concepts, policyholders can better manage their tax liabilities and make informed decisions about their life insurance policies.
