Policy Loan

It is a loan from the insurer secured by the policy's cash value, with any unpaid balance and interest deducted from the death benefit — A policy loan is an advance from the insurer against the policy's cash value. The loan is not taxable income because it is a loan, not a distribution, under IRC §72; interest accrues and the outstanding balance plus interest reduces the death benefit if unpaid at the insured's death. Loans reduce the cash value available, and if the loan with interest exceeds the cash value, the policy can lapse. The beneficiary has no lending role, and the debt is never forgiven — the net death benefit is simply reduced by the amount still owed.

National insurance concept

A taxable distribution, taxed on a LIFO basis with a possible 10% penalty before age 59½ — In a modified endowment contract (MEC), distributions, including policy loans, are taxed on a last-in-first-out (LIFO) basis, meaning the taxable gain comes out first. In addition, if the owner is under age 59½, a 10% penalty generally applies to the taxable portion of the distribution. This harsh treatment, imposed by IRC §7702A and §72(e), eliminates the tax advantages normally associated with borrowing against whole life and universal life policies. MECs are created when premiums exceed the 7-pay limit, often from large single deposits.

National insurance concept