When a policyowner borrows money from the cash value of a non-MEC life insurance policy through a policy loan, the loan proceeds are generally:
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Answer & full 3-part explanation (select an option above, or peek)
Why D is correct
A policy loan is a borrowing against the policy's cash value, not a distribution of income. Because the policyowner is receiving a loan that must be repaid, the transaction is not a taxable event under IRC §72. This is a major tax advantage of cash-value life insurance: the owner can access the cash value on a tax-free basis while keeping the policy in force. If the loan is later not repaid and the policy lapses or is surrendered, a taxable gain may result at that time, but the borrowing itself is not taxed. Loans from a MEC, however, are treated differently as distributions.
Why the other options are wrong
- A) A loan is not income in the year borrowed because the owner has an obligation to repay; income treatment under §72 is reserved for actual distributions, not borrowings. A debt is not a taxable accession to wealth.
- B) The amount of cash value does not make the loan taxable; a loan is a debt obligation, and borrowing against collateral is not income merely because the collateral has value.
- C) The repayment period is irrelevant to the tax treatment; a policy loan is not taxable at inception regardless of when or whether it is repaid. Repayment only restores the policy's loan balance.
Memory hook
Borrowing against cash value is not income — a loan is debt, and debt is not taxable.