Are Policy Loans Taxable? Lapses, MECs, and Death Benefits

Policy loans against permanent life insurance are generally not taxable while the policy stays in force. The IRS treats the money as a loan secured by your cash value, not as income. That tax-free treatment can disappear in three situations: the policy lapses with a loan balance, you surrender it with a loan balance, or the contract has been classified as a modified endowment contract. Knowing which situation you’re in is the difference between a tax-free source of cash and a surprise bill on money you’ve already spent.

Why a Loan Against Cash Value Isn’t Income

When you take a policy loan, the insurance company advances you money and holds a lien against your cash value until you repay it.¹ Because you owe the money back and the insurer has collateral, the cash you receive isn’t a distribution. It works the same way as borrowing against a home: pulling cash out of an asset you already own doesn’t generate a gain.

The Internal Revenue Code backs this up. Under Section 72(e)(5), amounts received from a life insurance contract that isn’t a modified endowment contract are taxable only to the extent they exceed your investment in the contract, which is the total premiums you’ve paid minus any amounts previously received tax-free.² A loan doesn’t withdraw funds from the policy at all, so no taxable event occurs while the contract is active.

Your cash value keeps earning interest or dividends while the loan is outstanding. The insurer charges interest on the borrowed amount; if you don’t pay it out of pocket, it’s added to the loan balance. State regulators typically cap fixed-rate policy loans somewhere in the 5 to 8 percent range, though variable-rate loans can run higher.

Loans and Withdrawals Are Taxed Differently

People use “withdrawal” and “loan” interchangeably. The tax code doesn’t. A withdrawal permanently reduces your cash value; a loan is a lien against it. That distinction controls when you owe tax.

For a non-MEC policy, partial withdrawals come out of your basis first under a cost-recovery rule.² If you’ve paid $80,000 in premiums, the first $80,000 you withdraw is tax-free. Pull out $85,000 and the extra $5,000 is ordinary income. Each withdrawal also permanently drops your basis by the amount withdrawn.

Loans don’t reduce basis at all. You can borrow more than your basis and still owe nothing, because it’s a loan rather than a distribution. If you’re planning to access large sums from a policy over time, loans preserve the tax cushion that withdrawals would shrink.

When a Lapse or Surrender Turns a Loan Into Taxable Income

This is where most policy loan tax problems happen. If the policy lapses because the cash value can no longer support the premiums and loan interest, or you surrender it while a loan is outstanding, the IRS treats the termination as a taxable event. The gain equals any cash you receive plus the outstanding loan balance, minus your cost basis.³ Revenue Ruling 2009-13 confirmed that surrender income is calculated under Section 72(e)(5), with amounts received included in gross income to the extent they exceed your investment in the contract.⁴

An example. You’ve paid $50,000 in premiums and taken a $70,000 loan. If the policy lapses, the $70,000 loan discharge counts as an amount received. Subtract the $50,000 basis and you have $20,000 in ordinary income. The top federal rate for 2026 is 37 percent for single filers with income above $640,600, and lower brackets still produce meaningful bills.⁵

Insurers call this phantom income because you receive no new cash when the policy ends, yet you owe tax on the forgiven loan. The insurance company reports the taxable gain to you and the IRS on Form 1099-R, which must be sent by January 31 of the year after the lapse.⁶ The income goes on Form 1040 lines 5a and 5b.³ Ignoring the form doesn’t help; the IRS already has a copy.

The same risk shows up in a Section 1035 exchange. If you swap an old policy for a new one and the old policy carried a loan that gets discharged in the exchange, the forgiven loan can be taxable “boot.” Paying off the loan before the exchange, or transferring the loan to the new policy where the carrier allows it, avoids the tax.

Modified Endowment Contracts Change the Rules

Overfunding a policy triggers a different tax regime entirely. A policy becomes a modified endowment contract if premiums paid during the first seven contract years exceed the amount needed to provide paid-up benefits with seven level annual payments. This 7-pay test is defined in Section 7702A and applies to contracts entered into on or after June 21, 1988.⁷

Once a policy is a MEC, it stays a MEC. Withdrawing excess premiums won’t undo the classification. And the tax treatment reverses: every loan from a MEC is treated as a distribution of gain first, before any basis recovery.² If your MEC holds $100,000 in cash value and $60,000 of that is gain, the first $60,000 you borrow is ordinary income.

Section 72(v) adds a 10 percent additional tax on taxable MEC distributions taken before age 59½, structured like the early-withdrawal penalty on retirement accounts.⁸ Between the income tax and the penalty, a MEC loan can consume close to half the taxable portion.

Three statutory exceptions relieve the 10 percent penalty:

Reaching age 59½. Income tax on gains still applies, but the penalty drops off.
Disability as defined in Section 72(m)(7).
A series of substantially equal periodic payments made at least annually over your life or life expectancy, similar to the 72(t) approach used with retirement accounts.

A narrow additional carve-out: if the MEC’s maximum death benefit is $25,000 or less, an assignment or pledge of the contract isn’t treated as a distribution.⁸ Outside these exceptions, the penalty applies regardless of what you use the loan for.

What Happens if You Die With a Loan Outstanding

If you die while a loan is unpaid, the insurer deducts the outstanding balance and accrued interest from the death benefit before paying beneficiaries. A $500,000 policy with a $75,000 loan pays out $425,000. Unpaid interest that has been compounding for years can make the reduction larger than the original borrower expected.

The payout keeps its tax-free status. Section 101(a)(1) excludes amounts received under a life insurance contract by reason of the insured’s death from gross income.⁹ The portion used to repay the loan doesn’t produce taxable income for the beneficiaries or the estate. The insurer settles the debt internally and pays the net.

Practically, this means dying with a policy loan is one of the more tax-efficient outcomes available. The borrower accessed cash tax-free during life, and the repayment at death comes out of proceeds that would have been tax-free anyway. Beneficiaries receive less, but nothing is taxable to anyone.

Is the Interest You Pay Deductible?

No. Interest on a policy loan against personally owned life insurance is classified as personal interest, and personal interest isn’t deductible.¹⁰ The rule has been in place since the Tax Reform Act of 1986 phased out the personal interest deduction.

There’s an added reason for the disallowance. Growth inside a policy is tax-deferred, so the IRS views policy loan interest as connected to producing tax-exempt income, which is separately non-deductible. Using the borrowed money for a business purpose doesn’t rescue the deduction when the policy is individually owned.

A Note on Business-Owned Policies

If a business owns the policy, different rules apply. Section 264(a)(4) generally disallows deductions for interest on debt tied to a systematic plan of borrowing against a life insurance contract’s cash value.¹¹ A limited key-person exception allows interest deductions on up to $50,000 of loan debt per covered officer or 20-percent owner, capped at the deductible rate by the Moody’s Corporate Bond Yield Average. Section 264(f) can also require businesses to allocate part of their overall interest expense to the unborrowed cash value of policies issued after June 8, 1997, making that portion non-deductible. If you’re dealing with a business-owned policy rather than a personal one, work through these rules with a tax advisor before borrowing.

1
Internal Revenue Service. IRS Internal Revenue Manual 5.17.2 Federal Tax Liens – Section: 5.17.2.6.5.9 Certain Insurance Contracts
2
Office of the Law Revision Counsel. 26 USC 72 Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
3
Internal Revenue Service – IRS.gov. For Senior Taxpayers 1
4
Internal Revenue Service. Internal Revenue Bulletin 2009-21
5
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
6
Internal Revenue Service. General Instructions for Certain Information Returns
7
Office of the Law Revision Counsel. 26 USC 7702A Modified Endowment Contract Defined
8
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
9
Office of the Law Revision Counsel. 26 U.S. Code 101 – Certain Death Benefits
10
Internal Revenue Service. Topic No. 505, Interest Expense
11
Office of the Law Revision Counsel. 26 U.S. Code 264 – Certain Amounts Paid in Connection With Insurance Contracts