Taking out a loan against your life insurance policy does not count as taxable income. However, that changes if you surrender your policy or the policy lapses, and the amount owed exceeds what was paid in. In that case, the loan becomes a taxable event. A Form 1099-R is issued, and you have to pay tax on the loan plus interest at your regular income tax rate. 

Key Takeaways

  • A life insurance policy loan is not taxable as income, as long as it doesn't exceed the amount paid in premiums for the policy.
  • If you surrender your policy or your policy lapses, the loan (plus interest) is considered taxable income by the IRS, at your ordinary-income rate.
  • While repaying a loan isn't mandatory, any debt outstanding upon the insured's death will be deducted from the policy payout to beneficiaries.

How Much of a Policy Loan Is Taxable?

The money you borrow is not taxable, as long as it is equal to or less than the sum of the insurance premiums you have paid when the policy terminates. A taxable amount equals the amount of the gain realized, which is any amount you received from the cash value of your policy minus the net premium cost, or the total of premiums paid minus distributions received. Let's say, for example, that you have a life insurance policy with a cash value of $400,000. You paid $100,000 in premiums but have a $300,000 balance on an outstanding policy loan with no distributions. If your policy lapses, the amount you have to claim as income on your taxes is $200,000. 

This can become a problem for some people, especially if their interest payments were not made out of pocket, but through dividends or through the cash value of the policy. Out-of-pocket interest payments are not tax deductible, so taxes are already paid on that amount.

But interest payments not made out of pocket often do not cover the entire amount of interest due, resulting in compound interest being added to the principal. If your loan sits untouched and accrues interest for decades with minimal interest payments made when a taxable event occurs, you may end up owing taxes on a balance that is substantially more than what you originally borrowed.

Other Considerations for Policy Loans

Getting a policy loan is usually quick and easy. You don’t have to go through an approval process because you are borrowing against your own assets. You can use the funds in any way you wish. Finally, you don’t have a repayment schedule or repayment date. Indeed, you don’t have to pay it back at all.

If a policy loan isn’t repaid, interest can significantly cut into the death benefit, which can put the policy at risk of not providing any money to beneficiaries.

However, if the loan is not paid back before the insured person's death, the insurance company will reduce the face amount of the insurance policy by what is still owed when the death benefit is paid. If you do pay back all or a portion of the loan, your options include periodic payments of principal with annual payments of interest, paying annual interest only, or deducting interest from the cash value. Interest rates can be as high as 7% or 8%. It's smart to at least make interest payments, so the policy loan doesn't grow.

In a worst-case scenario, if added interest increases the loan value beyond the cash value of your insurance, your life insurance policy could lapse and be terminated by the insurance company. In such a case, the policy loan balance plus interest is considered taxable income by the IRS, and the bill could be a hefty one.