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Executive Summary
Life insurance serves a valuable social purpose, allowing families to protect themselves against the economic consequences of an untimely death of a breadwinner. In fact, life insurance is viewed as such a positive that Congress provides significant tax preferences for insurance policies, including tax-deferral on any growth in the cash value, and a tax-free death benefit for the beneficiaries.
Another popular tax feature of life insurance is the ability to access the policy’s cash value in the form of a tax-free loan. However, in reality the tax-free treatment of a life insurance policy loan is not actually a preference for life insurance under the tax code, but the simple recognition that ultimately a policy loan is just a personal loan between the life insurance company and the policyowner, for which the life insurance cash value is collateral. A credit card cash advance isn’t taxable, nor is a cash-out mortgage refinance, and a personal loan from a life insurance company isn’t, either.
However, while a life insurance loan isn’t taxable – nor is its subsequent repayment – the presence of a life insurance loan can distort the outcome if/when a life insurance policy is surrendered or otherwise lapses. Because the insurance company will require that the loan be repaid from the proceeds of the policy.
In the case of a life insurance death benefit, this isn’t necessarily problematic. The death benefit is already tax-free, and the loan is simply repaid from the tax-free death benefit, with the remainder paid to heirs.