South Carolina Insurance Practice Exam

Funds obtained through loans against the cash value of a life insurance policy are treated as?

1. Taxable income

2. Non-taxable income

3. Subject to capital gains tax

4. Ordinary income

The correct answer is: Non-taxable income

Funds obtained through loans against the cash value of a life insurance policy are classified as non-taxable income. The reason for this classification lies in the nature of life insurance policy loans. When you take out a loan against the cash value of your policy, you are essentially borrowing money from the insurer. This loan does not constitute income in the traditional sense because the policyholder is expected to pay it back. In the context of taxation, the IRS does not treat these loans as taxable income because you are not receiving a profit but rather accessing your own accumulated funds within the policy. As long as the policy remains in force and the loan is repaid (with interest), there is no immediate tax implication. However, if the policy lapses or is surrendered, any unpaid loan amount may be subject to taxation as income, which highlights the importance of proper management of the policy and understanding the implications of loans taken against it. The options representing taxable income, capital gains, or ordinary income are not applicable because they generally involve realized gains or recognized income that affects the tax liability, unlike the non-taxable nature of loans against the cash value of a life insurance policy.