12 / How are policy loans under life insurance policies and endowment contracts treated?

Policy loans under life insurance policies and endowment contracts are not treated as distributions. However, the treatment differs for loans made from life insurance policies classified as modified endowment contracts.¹

If a loan is still outstanding when a policy is surrendered or allowed to lapse, the borrowed amount becomes taxable at that time to the extent the cash value exceeds the owner’s basis in the contract, as if the borrowed amount was actually received at the time of surrender or lapse and used to pay off the loan. (If a policy loan is outstanding at the time of an IRC Section 1035 tax-free exchange, the amount of the net reduction, if any, in the taxpayer’s outstanding loan will be considered “boot” and taxable as ordinary income at that time to the extent there is income on the contract, without regard to basis.) If a loan is outstanding at the time of death, the distribution of the face amount of the policy will be reduced by the amount of the outstanding loan. Proceeds received on account of the death of the insured are generally tax-free ( Q 63). The benefit of tax-free death proceeds in excess of cost may be lost, however, in the case of a policy transferred for value.