Tax Question on Cash Value of Life policy

Up to premiums paid is a withdrawal not taxable. Anything over that is a loan in which generally the insurance company charges you interest but also credits you the interest thus creating a wash loan. This is also not taxable. However, if the policy lapses it becomes taxable. At least this is how I remember it.

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So if he cashes it out and quits paying premiums, it's taxable. But if he continues to pay premiums, it wouldn't be?

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Correct, if he continues to pay premiums a portion of that will go to repayment of the loan. If he surrenders it prior to complete repayment then the remainder becomes taxable along with any interest due.

Yes, you do need to report it if your total withdrawal exceeds cost basis (your premiums).

The gain is taxable at ordinary income rates unless a loan was specified. When the income is requested by the policy owner, you will specify whether you would rather a loan or a withdrawal. Both will reduce the death benefit (assuming Universal Life). The loan being paid back will restore the original death benefit. Unless you decide to purchase additional insurance (and likely incur underwriting) the original death benefit in the event of a withdrawal cannot be restored. The loan would not be taxable unless the policy is eventually surrendered. In that case, your client would get a tax bill from Uncle Sam that would blow them out of the water.

Janky, not all companies administer wash loans. That is a relatively new development. Most of the policies pre-2005 or so have some sort of an interest spread in the favor of the company.