One of the reasons some people buy cash value life insurance is the potential to borrow money from the policy later on. When you bought your insurance policy, the insurance agent may have touted that you would be borrowing your own money and paying yourself back.
Insurance agents and companies may promote loans as an easy way to receive tax-free money from your life insurance policy. However, policy loans are more complicated than they appear.
Policy loans need to be reviewed and monitored. If a policy loan is not monitored, a policy could slowly deteriorate, losing the minimum cash value needed. This can leave you with the unpleasant choice of making substantial loan repayments or having a large phantom income tax gain.
What is a Life Insurance Policy Loan?
Policy loans are available on most permanent cash value life insurance policies. Policy loans are not the same as other loans: Policy owners are not required to repay the loan. Keep in mind, the insurance company will charge interest on the policy loan.
When you borrow money from your life insurance policy, you are borrowing your own money. It is essentially an advance of money that could be received from the policy either through a surrender of the policy or the payment of the death benefit. It is money that you, or your beneficiary, would have received anyway. The policy’s cash value acts as collateral for the policy loan.
If you never pay back the policy loan during your lifetime, the amount is deducted from the death benefit when you pass away—meaning that your beneficiaries repay the loan.
In Board of Assessors v. New York Life Insurance Company (1910), U.S. Supreme Court Justice Oliver Wendell Holmes wrote: “The so-called liability of the policyholder never exists as a personal liability, it is never a debt, but is merely a deduction in account from the sum the plaintiffs (the insurer) ultimately must pay.”
How Does a Life Insurance Policy Loan Work?
Life insurance policy loans are available on life insurance policies where there is sufficient cash value to borrow against. The available loan will be a percentage of the cash value. You must pay interest on the policy loan.
To initiate a policy loan, you’ll need to contact your life insurance company. Before taking out a policy loan, find out what will happen to the components of your policy after the loan. You can do this by requesting an in-force illustration that will reflect the policy loan based on your plans—whether you’ll borrow more money, repay the loan or maintain the loan.
Be sure the in-force illustration also reflects whether you will be paying interest on the loan out-of-pocket or if you will be borrowing interest as well.
And review the following terms of the loan.
The insurance company will charge interest in advance or in arrears:
- Interest in advance.The insurance company charges interest for the full year. This assumes that the loan is continued for that policy year. If the loan is taken out in the middle of a policy year, interest is charged for the remainder of the policy year at the time the loan is taken out. If a loan repayment is made during the policy year, the insurance company will typically not provide any credit or refund on the interest paid in advance.
- Interest in arrears. The insurance company charges interest at the end of the policy year. Interest accumulates daily. If a loan is taken out in the middle of a policy year, interest starts to accumulate that day. If you make a loan repayment in the middle of the policy year, this would decrease the daily loan interest amount, thereby decreasing the loan interest due at the end of the policy year.
The interest rate may be fixed or variable. Fixed interest rates are guaranteed, so you will know in advance what your loan interest will be each year. Variable interest rates can change each year. Variable interest rates will be disclosed on your policy’s annual statement and with premium notices when loan interest is due.
The money you have taken out can still earn gains. The insurance company will pay you interest (or dividends) on the amount borrowed, although this rate is usually lower than the interest rate credited to the remainder of cash value. On certain policies, you will receive the same interest rate.
Whole life insurance policies use the term “recognition” to define how much interest is credited to the amount of the cash value that is loaned out. If your life insurance company uses the non-direct recognition method, you will receive the same dividend on your all cash value. If your company uses the direct recognition method, you may receive a lower dividend on the amount of your cash value that constitutes the loan.
Whole life policies may also have an optional automatic premium loan provision. If you don’t pay your premium due, it is automatically deducted from the cash value through a policy loan.
Keep in mind that Interest on a policy loan is generally not tax-deductible.
How to Monitor a Life Insurance Policy Loan
The insurance company will not require you to pay back the loan balance. Nor do they provide any loan repayment schedule. You have the option each year to pay loan interest out-of-pocket or to borrow the interest. If you choose to borrow the interest, the loan balance will compound, which means that the interest due each year will compound.
It’s important to request an in-force policy illustration annually to determine the impact of a policy loan. Your request should include the following scenarios along with any others that reflect your plans:
- Re-paying the policy loan in-full
- Paying premiums and interest out-of-pocket
- Borrowing future premiums and loan interest
- Showing what happens if your current premium payments stay the same
- Showing the premium needed to endow the policy at maturity
- Any other action you’re considering, such as taking a partial withdrawal or changing your dividend option
Why is a Life Insurance Policy Loan Dangerous?
The in-force policy illustration will help you determine how long your policy will remain in-force. You will find that the larger the loan, the more impact it will have on your policy.
For example, with an initial policy loan of $50,000 and a loan interest rate of 8%, the loan interest in year 1 will be $4,000. If you borrow the loan interest, your loan balance would increase to $54,000 (initial loan amount of $50,000 plus the loan interest of $4,000). The loan interest in year 2 would increase to $4,320. The loan balance would increase to $58,320, if the loan interest is borrowed again ($54,000 loan balance plus the loan interest of $4,320). As you can see, this rapidly increases the policy loan balance
Here’s how it works:
On a permanent cash value life insurance policy, the cash value increases every year. This reduces the total risk to the insurer because it will pay out only the death benefit when you pass away and absorb the cash value. Mortality costs—the actual cost of insurance for you—are also increasing each year because you get older. But that increase is usually offset for the insurer by the decreasing amount at risk.
If you’ve taken out a loan from the cash value, the lower cash value will result in lower earnings. If your premium payments aren’t enough to cover the mortality cost and other fees, the insurer will take it from your cash value. Now your cash value is being depleted by multiple demands—the loan, lower earnings and fees. And if the cash value goes to zero the policy will terminate, unless you make an infusion of premium.
If the policy terminates, you’ll get dinged by an income tax bill on the loan money you took.
(Read more: The Pitfalls of Policy Loans The Pitfalls Of Policy Loans)
Calculating Taxable Income from a Policy Loan
Here’s how to calculate the potential gain in the policy that would be subject to income tax:
- Add the net cash (surrender) value, any dividends received (either prior or accumulated) and the outstanding loan balance.
- Subtract the cost basis (sum of premiums paid into the policy).
Example: If a life insurance policy terminates with a loan balance of $100,000 and a cost basis of $50,000, the taxable gain would be $50,000.
Please note that the above example is a general rule and may not apply to every situation. You should consult your tax advisor to confirm whether you have a taxable gain.
Your life insurance company will be able to provide you with the cost basis, along with the gain that they will report to the Internal Revenue Service as 1099 income.
While a policy loan can provide you with immediate funds, it can have a number of drawbacks. Know what you’re getting into before you take the cash.
This article originally appeared on Forbes Advisor (here).