How are policy loans from a whole life policy treated for tax purposes?

When a policyholder takes a loan against a whole life insurance policy, the amount borrowed is not considered taxable income at the time the loan is taken. This is because loans from life insurance policies are treated as borrowed funds rather than income. The policyholder is essentially accessing their own money, which has already been taxed through premiums paid.

However, any interest that accrues on the loan is important to note. If the loan is not repaid, the unpaid interest will accumulate and will reduce the death benefit payable to the beneficiary upon the policyholder's death. This means that while the loan itself does not incur immediate tax implications, the potential decrease in the death benefit due to unpaid interest is a significant consideration for the policyholder. The original intent of the insurance policy, which is to provide a financial benefit to beneficiaries, can be affected if the loan is not managed properly.

The other options present incorrect situations: policy loans are not recorded as taxable income upon withdrawal, nor are they tax-deductible expenses, and they are certainly not prohibited under standard insurance practices.