Generally, any increase in the cash value of a life insurance policy is not subject to current income taxation as long as the policy meets the statutory definition of life insurance. However, if a policy does not meet the definition, any increase in the cash value will be taxed as ordinary income annually as received or accrued by the policyholder.
How are policy loans taxed?
Policy loans taken from a life insurance policy are not taxable unless the policy is a modified endowment contract. If the insured dies while the loan is outstanding, the loan will be repaid out of the death benefit and no taxation should occur.
However, there may be tax ramifications if the policy is surrendered, lapses or is exchanged while a loan is outstanding.
What are the tax ramifications if the policy is surrendered?
If the policy is surrendered, then the cash value will be taxable as ordinary income to the extent it exceeds the owner’s contributions to the contract. Any loss incurred is non-deductible and a personal expense. In addition, loan balances in excess of the owner’s contribution to the policy may also be taxed upon a full surrender.