PSI Life Exam Practice Test

Under an executive bonus plan, how are funds taken as loans from the policy treated?

1. Tax-free for the employee

2. Reported as taxable income to the employee

3. Not required to be reported

4. Considered as bonuses

The correct answer is: Reported as taxable income to the employee

Under an executive bonus plan, funds taken as loans from the policy are reported as taxable income to the employee. This means that when the employee takes a loan against the cash value of a life insurance policy associated with the executive bonus plan, the amount of the loan is treated as additional income. This situation arises because the Internal Revenue Service (IRS) rules state that borrowed amounts from a policy are considered taxable income if the policy is a modified endowment contract (MEC), or if the policy is surrendered or lapses without being fully repaid. If an employee were to default on the loan, it could result in a taxable event. Therefore, it’s essential for employees to understand that such loans can increase their taxable income and may have tax implications if not managed properly. This makes reporting essential for tax calculations and compliance.