Yes, if the policy is a permanent one with cash value. Whole life, universal life, indexed universal life and variable universal life all accumulate a cash value the owner can reach. Term insurance has none, so there is nothing to borrow against.
A policy loan is genuinely useful and it is also the single most common way people accidentally trigger a tax bill on a life insurance policy. Both facts deserve the same amount of attention.
What cash value is
Each premium payment on a permanent policy splits three ways. Part covers the cost of insurance, which is the carrier’s charge for the death benefit and rises as you age. Part covers expenses and commissions, which are heaviest in the early years. What remains goes into the cash value, where it grows without current income tax.
That structure explains the shape of the early years. A permanent policy’s cash value in years one to three is usually far less than the premiums paid, because the front-loaded charges come out first. The account catches up later. Surrendering early is where people lose real money, and it is why permanent insurance is a poor fit for anyone who may need the premium back within a few years.
The three ways to get at it
A policy loan. You borrow from the carrier using the cash value as collateral. There is no credit check, no application, no repayment schedule, and no restriction on what you use the money for. Interest accrues, and if you never repay, the loan balance plus accrued interest is deducted from the death benefit.
This is the mechanism people mean when they talk about a policy being a source of capital. It works, and it is not a taxable event while the policy remains in force.
A withdrawal, or partial surrender. You take money out permanently. Under normal life insurance tax treatment, withdrawals come out basis-first: you can withdraw up to the total premiums you paid without tax, and only the amount above that is taxable. Withdrawals reduce the death benefit, sometimes by more than the amount withdrawn depending on the policy.
Surrender. You cancel the policy and take the cash surrender value, which is the cash value less any surrender charge and any outstanding loan. Gain above your basis is ordinary income. The coverage ends.
What a loan actually costs
Two numbers decide that, and they are not the same at every carrier.
The loan interest rate is what the carrier charges. Older whole life policies often have a fixed rate written into the contract. Newer policies more often use a variable rate.
The crediting treatment is what still gets paid on the borrowed portion. Under a wash or direct recognition arrangement, the carrier credits the borrowed amount at a different, usually lower, rate than the unborrowed portion. The net cost of the loan is the spread between the two, not the headline interest rate.
This is where indexed universal life illustrations used to be aggressive. The National Association of Insurance Commissioners addressed it in Actuarial Guideline 49-A, effective at the start of 2021, which cut the illustrated advantage by “reducing the difference in the loan interest rate credits and loan interest rate charges from 100 basis points to 50.” Illustrations produced before that showed borrowing arbitrage that could not be illustrated afterwards.
The trap: what happens if the policy lapses
A policy loan is not income while the policy is in force. If the policy lapses or is surrendered with a loan outstanding, the loan is treated as though it were paid to you at that moment, and the tax consequence arrives with no cash to pay it.
The Tax Court set this out plainly in Doggart v. Commissioner, T.C. Summary Opinion 2023-25, decided on July 27, 2023. Mr. Doggart was incarcerated beginning in February 2017 and stopped paying premiums on two Prudential policies. The policies lapsed, and Prudential applied the cash values to repay the outstanding loans and accrued interest. Prudential reported taxable distributions of $13,214 on one policy and $5,366 on the other.
Doggart received no money. The court held that a constructive distribution occurred anyway when the cash values were applied to extinguish the loans, stating that “a constructive distribution is included in gross income insofar as it exceeds the taxpayer’s investment in the life insurance contract,” and that it is “irrelevant that no money changed hands.”
The mechanics that produce this are worth understanding because they are gradual and quiet. Interest accrues on the loan. If it is not paid in cash, it is added to the loan balance. The larger balance accrues more interest. Eventually the loan plus interest approaches the cash value, the policy has nothing left to support its charges, and it lapses. Whatever gain existed becomes income in that year.
The worst version happens in retirement, to someone who borrowed heavily against a policy for years on the understanding that the loans were tax free. They were, right up until the policy failed.
How to keep that from happening
- Ask for an in-force illustration. Every carrier will produce one on request, showing how the policy is projected to perform from today with the current loan balance and current crediting. Ask for it every year or two on any policy carrying a loan.
- Pay the loan interest in cash where you can. This stops the balance compounding, which is the mechanism that kills these policies.
- Watch the ratio. A loan balance approaching a large share of the cash value is a warning, not a milestone.
- Do not simply stop paying premiums. If a policy has become unaffordable, there are usually better exits: reduced paid-up coverage, extended term, a 1035 exchange into a different contract, or a life settlement. All of them are better than lapse with a loan.
- Talk to a tax adviser before surrendering. The taxable amount is computed on the gain, and with a loan outstanding it can exceed the cash you actually receive.
If the policy is a modified endowment contract
All of the above assumes normal life insurance tax treatment. A policy funded too quickly is taxed differently.
Internal Revenue Code section 7702A defines a modified endowment contract as one that fails the seven-pay test, which happens if the amount paid into the policy in its first seven contract years exceeds the net level premiums that would have paid it up in seven annual payments.
Inside a modified endowment contract, distributions and loans come out gain-first rather than basis-first, are taxable to the extent of gain, and carry a 10% penalty before age 59 and a half. The death benefit remains income tax free. The living benefits, which is usually why the policy was overfunded in the first place, do not.
If your policy was designed to be heavily funded, it should have been designed against that line deliberately. Whether it was is a question worth asking now rather than at the point you want the money.
What we do with this
Apex reviews in-force policies clients bring us, including ones we did not write. That review reads the loan balance, the current crediting, the projected year of lapse and whether a 1035 exchange or a policy change would produce a better outcome than continuing.
If you are carrying a loan and have not seen an in-force illustration in a few years, that is the thing to fix first. Talk to a member of our team, or read how indexed universal life credits interest.
Nothing here is tax advice. Talk to your own tax adviser about your situation. Policy provisions vary by contract and carrier. No policy is bound until a carrier issues it in writing.
