PSI Life Exam Practice Test

How are policy loan proceeds generally treated for tax purposes?

1. Treated as taxable income

2. Not treated as taxable income

3. Considered tax-deductible expenses

4. Tax-exempt under all circumstances

The correct answer is: Not treated as taxable income

Policy loan proceeds are generally not treated as taxable income because they are considered a loan against the cash value of a life insurance policy. When a policyholder takes out a loan, they are essentially borrowing their own money, which does not trigger a taxable event. This treatment is based on the principle that loans do not constitute income; instead, they create an obligation to repay. The underlying cash value of the policy serves as collateral for the loan, and since the insured has already paid taxes on the premiums used to build that cash value, the IRS does not consider the loan itself as taxable income. This aspect is particularly advantageous for policyholders, as it allows them to access funds without incurring immediate tax liabilities. It’s important to note that if the policy is surrendered or lapses and the loan is outstanding, the amount of the loan can be treated as taxable income to the extent that it exceeds the total amount of premiums paid into the policy. However, under normal circumstances, the loan proceeds themselves remain tax-free.