How are policy loans taxed?

• A. Policy loans are always taxed when taken.
• B. Policy loans are taxed only if the insured dies.
• C. Policy loans are generally not taxed as income until the policy lapses or is surrendered, except if the policy is a MEC where loan withdrawals are taxed.
• D. Policy loans are taxed at withdrawal but not at lapse.

Answer: (C)

Policy loans are not normally taxed as income while the policy remains in force. A loan against the cash value is simply borrowing your own money from the insurer, so no taxable event occurs at the time you take the loan. The policy can keep growing tax-deferred, and you owe the loan plus interest to the insurer.

Tax consequences arise if the policy lapses or is surrendered with an outstanding loan. In that case, the loan is treated as a distribution to the extent the policy’s gains (earnings) exceed the cost basis. Those gains are taxed as ordinary income to the insured.

If the policy is a Modified Endowment Contract (MEC), access to cash value through loans or withdrawals is taxed as a distribution of earnings, meaning any amount withdrawn or loaned is taxed to the extent of the policy’s earnings, regardless of the basis.