Tax Treatment of Life Insurance and Annuity Accrued Interest

January 1990 TAX POLICY*

Borrowing Against Inside Buildup Is Tax-Free for Life Insurance but Taxable with a Penalty for Annuities

If a policyholder borrows the inside buildup from his or her life insurance policy, the amount borrowed is considered a transfer of capital, not a realization of income, and, therefore, is not subject to taxation. This reasoning is in accord with tax policy on other types of loans, such as consumer loans or home mortgages. These loans are merely transfers of capital or savings from one person to another through a financial intermediary. The ability to borrow against a life insurance policy means that the interest income that is supposed to be building up to fund death benefits can instead be a source of untaxed current income. If the loans are not repaid, the inside buildup will never be taxed; death benefits will simply be reduced by the amount of the loan. Thus, policyholders have the use of tax-free income for purposes other than insurance at the expense of reduced death benefits for the beneficiaries.

*Government Accounting Office Document 148632 January 1990 (Tax Treatment of Life Insurance and Annuity Accrued Interest) GAO/GGD 90-31