South Carolina Insurance Practice Exam

When borrowing against a life insurance policy, what is the tax treatment of the loan?

1. It is subject to income tax

2. It is tax-free

3. It results in taxable gains

4. It is considered ordinary income

The correct answer is: It is tax-free

When a policyholder borrows against a life insurance policy, the loan is generally considered tax-free. This tax treatment applies because the IRS does not treat the borrowed amount from a life insurance policy as income; rather, it is seen as a loan against the cash value of the policy. Consequently, as long as the policy remains in force and the borrower does not have to pay the loan back (for instance, if the policy lapses), the loan itself is not subject to immediate taxation. However, if the policy is surrendered or lapses while there is an outstanding loan, then any portion of the loan that exceeds the policyholder's basis in the policy could be subject to taxes as it may be considered a distribution. Thus, as long as the conditions for the loan are maintained, that is, the policy remains active and the loan is managed properly, the tax treatment remains favorable, allowing access to cash without immediate tax implications.