Are Life Insurance Loans Taxable? What You Need to Know

Borrowing against a life insurance policy provides access to cash without credit checks or strict repayment terms. However, tax consequences depend on how the loan is managed and whether the policy remains in force.

Understanding when a life insurance loan might become taxable helps avoid unexpected liabilities. Certain scenarios, such as policy lapses or surrender, can trigger taxes that borrowers may not anticipate.

Tax Treatment of Policy Loans

Life insurance loans are generally not taxable because they are borrowings against the policy’s cash value rather than withdrawals. Since the loan is secured by the policy, the IRS does not treat it as income. This tax-free status remains as long as the policy stays active.

Permanent life insurance policies, such as whole life and universal life, accumulate cash value over time. When a policyholder takes out a loan, they are borrowing against their own asset rather than receiving income. Because of this, the IRS does not categorize the loan as taxable. Additionally, there are no restrictions on how the borrowed funds are used, making them a flexible financial tool.

Interest accrues on the loan and, while it does not create an immediate tax liability, it can impact the policy’s long-term performance. If unpaid interest accumulates, it increases the total loan balance, reducing the death benefit available to beneficiaries. Some policies allow interest payments to be added to the loan principal, compounding the amount owed. If the loan balance approaches the policy’s cash value, the policyholder may need to repay part of the loan or add premiums to keep the policy in force.

Circumstances That Trigger Taxable Events

A life insurance loan remains tax-free unless specific events occur. One situation arises when the loan balance exceeds the policy’s cost basis—the total amount of premiums paid. If the policy is terminated under these conditions, the excess amount is taxable income.

Another instance is when a policyholder takes a partial withdrawal while a loan is outstanding. If the withdrawal reduces the cash value enough to put the policy at risk of lapsing, the insurer may use the remaining value to cover the loan. If the amount used exceeds the cost basis, it is taxable income.

Some policyholders continuously borrow without repaying the balance. If the loan, including accrued interest, surpasses the available cash value, the insurer may cancel the policy. In this case, the IRS treats the forgiven loan amount as taxable income.

Lapse or Surrender Considerations

If a policyholder surrenders a life insurance policy, the tax implications depend on how the cash surrender value compares to the total premiums paid. If the surrender value exceeds the premiums contributed, the difference is taxable as ordinary income.

A policy lapse occurs when the cash value is insufficient to cover insurance costs, often due to excessive borrowing or failure to pay premiums. If a lapsed policy had an outstanding loan, the IRS considers the forgiven loan balance taxable if it exceeds the cost basis. Unlike a surrender, where policyholders receive a payout, a lapse can result in taxes due without any cash proceeds to offset the liability.

How Interest Affects Tax Calculations

Interest on a life insurance loan can create tax consequences, particularly when it compounds. Unlike traditional loans with set repayment schedules, policy loans often allow interest to be capitalized—added to the loan balance. This increases the total debt and can accelerate the risk of a taxable event if the loan surpasses the policy’s cash value.

If a policy is classified as a Modified Endowment Contract (MEC) under Internal Revenue Code Section 7702A, it is subject to different tax treatment. MECs follow the “last-in, first-out” (LIFO) rule, meaning any distributions, including unpaid loan interest that reduces the policy’s value, are considered taxable earnings before the return of principal.

Impact on Policy Value

Borrowing against a life insurance policy reduces its cash value and can have long-term financial consequences. While the loan provides liquidity, the outstanding balance limits the amount available to grow through interest or dividends. This diminished growth potential can affect the policy’s ability to sustain itself, particularly in policies that rely on cash value accumulation to cover insurance costs. If the loan balance becomes too large relative to the remaining cash value, the policy may require additional premium payments to stay in force.

For policies that pay dividends, such as participating whole life insurance, an outstanding loan can reduce the dividend amount. Many insurers calculate dividends based on the net cash value after deducting any loans, which means policyholders may receive lower payouts. A significant loan balance can also limit funds for retirement income or other financial goals, requiring adjustments to a broader financial strategy.

Reporting Requirements

While life insurance loans are not typically reported to the IRS as taxable income, certain situations require policyholders to account for them on tax filings. If a policy lapses or is surrendered with an outstanding loan, the insurer will issue a Form 1099-R, detailing the taxable portion of the loan balance. This amount must be reported as ordinary income, and failure to do so can result in penalties or interest on unpaid taxes.

For policies classified as Modified Endowment Contracts (MECs), any loan or withdrawal is subject to immediate taxation on the earnings portion. Insurers track these distributions and report them accordingly. Policyholders should review their annual policy statements and consult a tax professional to ensure compliance. Proper documentation is essential to avoid unexpected tax liabilities and ensure accurate filings.