Taking out a loan against your life insurance policy does not count as taxable income, according to the IRS. However, if you surrender your policy or your policy lapses, the IRS is notified of this taxable event and you have to pay tax on the loan plus interest at a regular income tax rate. This can become a problem for some people, specifically if their interest payments were not made out of pocket, but through dividends or the cash value of the policy.
Out-of-pocket interest payments are not tax deductible, so taxes are already paid on that amount. Interest payments that are 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 has been sitting untouched and accruing interest for decades with minimal interest payments made, when a taxable event occurs, you could end up owing taxes on a balance that is substantially more than what you originally borrowed.
The taxable amount is 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. For example, say 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.