Life Insurance Taxation Nuances

Phantom Income Tax

We all know Benjamin Franklin’s famous words, “In this world nothing can be said to be certain, except death and taxes.”  While this statement remains true, tax laws continue to flux, evolving the amount of income, capital gains, estate, state-level, property, etc. taxes that are due each year.  While the 2025 tax law did not have a drastic effect on the insurance industry as a whole, there are some tax-related nuances to consider when adding insurance products to a financial portfolio or when auditing existing policies.

Policy loans are a means of accessing life insurance policy cash values within a permanent life insurance policy without having to surrender the policy.  When contemplating a policy loan, the policy owner would first consider making a withdrawal from the life insurance policy. The cash value can be withdrawn up to the cost basis (the amount of the total premiums paid into the policy) without incurring taxes. A withdrawal of any gains in the policy would be taxed as ordinary income. Any amount that is needed from the cash value over cost basis should be accessed via a policy loan.

All states require the inclusion of a policy loan provision in permanent policies. Insurance carriers must honor requested loans to policy owners when there is sufficient cash value inside the policy. Policy loans are collateralized internally by the policy cash value, subject to internal interest rates that are determined by the insurance carrier. The borrowed cash value isn’t deducted from the policy and continues to earn and grow while the policy remains inforce.

A policy loan is not generally considered a taxable event. However, this tax treatment relies upon the policy remaining in force until the insured’s death, and not becoming a Modified Endowment Contract (MEC). When a non-MEC policy is terminated other than by the insured’s death (by lapse or surrender), any outstanding loans are taxable at ordinary income tax rates to the extent there is gain in the policy above basis.  This is sometimes considered a “phantom” tax, because the policy loan might have been taken years or decades previously and the client won’t be expecting a tax bill in the current year.

If a heavily loaned policy is no longer wanted or needed, we encourage our clients and their advisors to explore policy loan rescue ideas before surrendering or lapsing the policy.  We are happy to navigate these options with you or your clients.

Contact us with any questions or opportunities to help you or your clients achieve identified goals. This is what we enjoy doing for only a select number of families, businesses, and charitable institutions each year, and we look forward to hearing from you.