A policyowner borrows money from the cash value of a life insurance policy. Under federal tax law, the loan proceeds are generally:
Select an option to reveal the answer and the full 3-part explanation — free, no signup.
Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
Money borrowed from the cash value of a life insurance policy is a loan, not income, and is generally not taxable to the policyowner. The loan is secured by the policy's cash value, and the policyowner must repay it with interest or the amount will be deducted from the proceeds at death or surrender. Because no income is realized when the loan is made, there is no federal income tax on the loan proceeds. This tax treatment differs from a withdrawal of cash value in excess of cost basis, which can be taxable, and from loans on modified endowment contracts, which are treated as taxable distributions.
Why the other options are wrong
- Loan proceeds are not ordinary income because the policyowner has incurred a debt; a loan is not a distribution of earnings or profit. This answer describes a different situation from the one in the question and is therefore incorrect under the facts given here.
- There is no rule that loans become taxable if they are unpaid within one year; unpaid loans simply reduce the death benefit or cash value. This choice does not fit the arrangement described in the question, so it is clearly not the right option to choose.
- A 10% penalty applies to early distributions from qualified retirement accounts and certain modified endowment contracts, not to ordinary policy loans. Accordingly, this option is not correct because it does not match the specific rule or product that is described in the question.
Memory hook
A loan is not income, so borrowing the cash value stays tax-free.