Washington Life Producer Practice Exam

How are loans obtained by a policyowner against the cash value of a life insurance policy treated for tax purposes?

1. Treated as taxable income

2. Not treated as taxable income

3. Considered capital gains

4. Exempt from all taxes

The correct answer is: Not treated as taxable income

When a policyowner takes a loan against the cash value of a life insurance policy, the loan amount is not treated as taxable income. This is because the Internal Revenue Service (IRS) considers these loans to be a borrowing against the policy rather than a withdrawal. As long as the policy remains in force, and the loan is repaid, there are no immediate tax implications. This characteristic allows policyowners to access funds without triggering income tax, differentiating it from other financial transactions that may incur tax liability. It’s important to note that if the policy is surrendered or lapses and there is an outstanding loan balance, the amount exceeding the policy's basis may be subject to taxation. However, as long as the policy remains active and the loan is not significant enough to impact the policy’s status, the funds remain tax-deferred. This aspect of life insurance loans makes them an attractive financial tool for accessing cash while maintaining the benefits of the policy.