Are Infinite Banking policy loans tax-free?

First identify the transaction

Borrowing, withdrawing, and surrendering are different transactions. A loan creates an obligation secured by policy values. A withdrawal or partial surrender removes value under the policy’s provisions. A full surrender terminates the contract.

The MassMutual income-tax guide explains ordinary policy-loan treatment and the possibility of a distribution when a policy lapses with debt. This is issuer educational material; it is not a tax ruling for your policy.

The tax basis is also not always equal to the sum of checks you remember sending. Prior transactions can affect it. Ask the insurer for the current investment in the contract and a tax estimate before a consequential transaction.

What is a modified endowment contract?

A MEC is a life insurance contract with different treatment for certain lifetime distributions. Internal Revenue Code section 7702A defines the category and its seven-pay test. It is not a universal dollar limit or a rule that disappears after the first seven calendar years.

Material changes and certain benefit reductions can affect testing. The insurer needs to calculate the applicable limits for the actual contract. The IRS’s 2024 information letter on life insurance and MECs provides general statutory context; it does not approve any individual policy design.

If non-MEC treatment is important to the plan, obtain confirmation before sending additional premiums or making changes. Do not use a guessed annual premium ceiling.

MEC loans are not ordinary nontaxable borrowing

Section 72(e) applies income-first treatment and loan-related distribution rules to MECs. Section 72(v) generally imposes a 10% additional tax on the taxable portion, with exceptions including distributions at or after age 59½ and certain disability or payment circumstances.

This is an additional tax on the taxable portion, not a universal 10% charge on every dollar borrowed. Age 59½ does not erase ordinary income tax on a taxable distribution.

Hypothetical example: A MEC has $80,000 of value and $60,000 of basis, with no prior distributions. If a $10,000 loan is treated as a distribution under the applicable rules, the $20,000 gain means the $10,000 could be fully taxable. If the additional tax applies, 10% of that taxable amount is $1,000, separate from ordinary income tax.

This simplified example is not a tax determination and excludes special circumstances and other transactions.

Lapse can create tax without a new check

Outstanding policy debt may become relevant to a taxable distribution when a policy terminates. You can have taxable income even when little or no new cash is paid to you at that moment.

Hypothetical illustration: Assume the insurer calculates $90,000 as the total deemed distribution on termination, including debt, and confirms a $60,000 tax basis with no other adjustments. The difference is $30,000 of potentially taxable gain. The new cash received could be much less than $90,000 because debt is involved.

The insurer and your tax professional must determine the actual amounts. The IRS Publication 525 surrender guidance explains that surrender proceeds exceeding the investment in the policy are included in income and discusses basis adjustments. It should not be replaced with a calculation based only on the final check.

Withdrawals have their own rules

Ordinary non-MEC distributions can generally recover basis before gain, but exceptions and special rules can matter, including certain early reductions of benefits. Do not assume that every withdrawal described as “taking my premiums back” has no tax consequences.

Similarly, exchanging a policy is not a shortcut that automatically removes loan or MEC issues. Proposed exchanges, ownership changes, and debt reductions require their own analysis. This initial article does not provide a transaction plan for those cases.

Questions to ask before borrowing or changing a policy

Obtain current MEC status, tax basis, debt including interest, net surrender value, and an in-force illustration. Ask what happens if the planned loans continue with lower nonguaranteed values or reduced funding.

If a proposal’s success depends on avoiding a future lapse, that management obligation belongs in the decision—not only in the footnotes. See what happens if funding stops.