A. Normally, no tax liability will arise at any time when life insurance or endowment dividends are used to purchase paid-up insurance additions.
Dividends not in excess of investment in the contract are not taxable income, the annual increase in the cash values of the paid-up additions is not taxed to the policyholder, and death proceeds are tax-free.
In effect, dividends reduce the cost basis of the original amount of insurance and constitute the cost of the paid-up additions. Consequently, upon maturity, sale, or surrender during an insured’s lifetime, gross premiums, including the cost of paid-up additions, are used as the cost of the insurance in computing gain upon the entire amount of proceeds, including proceeds from the additions.