A policyowner takes a loan from the cash value of a non-MEC whole life policy. For federal income tax purposes, the loan:
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
A policy loan is a borrowing against the cash value, not a taxable distribution, so taking the loan generally does not trigger income tax. By contrast, withdrawals and cash surrenders are taxable to the extent they exceed the policyowner's cost basis, under IRC Section 72. Special rules apply to modified endowment contracts, where loans and withdrawals are taxed on a gain-first, LIFO basis. Because the loan is secured by the cash value and must be repaid with interest, the IRS does not treat it as income when received. The death benefit remains income tax free even if a loan is outstanding, though the loan is deducted from the proceeds.
Why the other options are wrong
- Loans are not income; they are advances against the policy's cash value that must be repaid with interest, so they do not create taxable income.
- A loan is not a dividend; dividends are distributions of corporate profits, while a policy loan is a borrowing from the insurer.
- The loan itself is not deductible, and the interest on a personal policy loan is generally not deductible for income tax purposes.
Memory hook
Borrowing from cash value is a loan, not a payout — no tax when you take it.