A policy loan (also called a policy advance) is an amount the insurer advances to the policyholder, secured by the policy's cash value. Key tax features:
- A policy loan is not a disposition and does not trigger income inclusion at the time of borrowing. The policyholder receives cash without immediate tax.
- The loan must be repaid with interest; the interest is generally not deductible unless the policy is held for business purposes and meets the ITA's deductibility conditions.
- If the policy is surrendered while a loan is outstanding, the outstanding loan balance is included in the proceeds of disposition. The full surrender value plus any accrued interest on the loan is compared against ACB; the excess is income.
- On death, the outstanding loan is deducted from the death benefit paid to the beneficiary. The death benefit itself remains tax-free (from an exempt policy), but the beneficiary receives the face amount minus outstanding loan and interest.
Leveraging strategies: some clients use policy loans to access cash tax-free and repay the loan from the tax-free death benefit at death. Agents must understand this strategy's risks (interest accumulation can erode the death benefit) and ensure it is appropriate to the client's situation and complies with anti-avoidance provisions.
Recall: Does taking a policy loan trigger an immediate tax obligation? What effect does an outstanding loan have on the death benefit received by the beneficiary?