Investment Company and Variable Contracts Products Representative (Series 6)Practice Exam

What is the tax implication of a policy loan taken against a life insurance policy?

1. The loan is fully taxable to the insurer

2. The loan is not taxed, but interest is charged on the outstanding balance

3. The loan amount is considered taxable income

4. The loan is tax-free until repaid

The correct answer is: The loan is not taxed, but interest is charged on the outstanding balance

A policy loan taken against a life insurance policy typically does not trigger a tax liability at the time the loan is taken. This is because, under Internal Revenue Code Section 7702, loans against the cash value of a life insurance policy are generally not considered taxable income as long as the policy remains in force and is not surrendered or lapses. While the loan itself is not taxed, it is essential to note that interest is charged on the outstanding balance of the loan. This interest can accumulate and may impact the overall cash value of the policy and the death benefit if the loan is not repaid prior to the policyholder's death. If the policy lapses with an outstanding loan, then the amount of the loan may become taxable as income up to the total cash value of the policy minus any premiums paid. In understanding the tax implications of a policy loan, it's important to recognize that while the loan amount is neither taxed upon issuance nor considered taxable income, the ongoing interest on that loan is a crucial factor to consider for overall financial planning.