29 / Are life insurance policy loans taxable?

A loan taken from a life insurance policy that is not classified as a modified endowment contract under IRC Section 7702A is not includable in income because it is not treated as a distribution under IRC Section 72.¹

By contrast, a loan taken from a life insurance policy that is classified as a modified endowment contract is treated as a distribution under IRC Section 72 and is includable in income at the time received to the extent that the cash value of the contract immediately before the distribution exceeds the investment in the contract ( Q 13).² Unless the loan is made under certain specific circumstances ( Q 13), a 10 percent penalty tax is imposed on the amount of the loan that is includable in gross income.³

If a loan is still outstanding when a policy is surrendered or allowed to lapse, the borrowed amount becomes taxable at that time to the extent the cash value exceeds the owner’s basis in the contract, as if the borrowed amount was actually received at the time of surrender or lapse and used to pay off the loan.⁴ If a loan is outstanding at the time of death, the distribution of the face amount of the policy usually is reduced by the amount of the outstanding loan.

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Planning Point: Because withdrawals from life insurance policies not classified as modified endowment contracts are ordinarily not subject to income tax up to the amount of cost basis in the contract, it is typical to first take withdrawals until basis is exhausted and then take policy loans. By taking withdrawals up to basis and then by taking loans after that, amounts received from the policy during lifetime can be maximized and income taxes minimized. However, it is important that a program of withdrawals and loans be carefully monitored so as not to result in a policy lapse which could cause adverse income tax consequences as well as loss of the policy death benefit.

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