Borrow Against Your Life Insurance Policy Tax-Free

Life insurance policies can provide more than just a death benefit for beneficiaries. Certain types of policies also accumulate a cash value component, which can serve as a financial resource during the policyholder’s lifetime. This accumulated value can be accessed through policy loans, offering a flexible way to obtain funds.

Life Insurance Policies with Cash Value

Cash value life insurance refers to permanent life insurance policies that include a savings feature. These policies provide coverage for the policyholder’s entire life, unlike term life insurance which covers a specific period. A portion of each premium payment contributes to this cash value, which grows over time.

Whole life insurance is a common type of permanent policy where the cash value grows at a guaranteed interest rate. Premiums for whole life policies are fixed and remain the same throughout the policy’s duration. This predictability offers stability for financial planning.

Universal life insurance offers more flexibility, allowing policyholders to adjust premiums and death benefits within certain limits. The cash value in a universal life policy typically earns interest based on rates set by the insurer, often with a guaranteed minimum rate. This adaptability can be beneficial as financial circumstances change.

Variable universal life insurance is another permanent policy where the cash value is invested in various sub-accounts, similar to mutual funds. This offers the potential for higher returns, but also carries investment risk. Indexed universal life insurance links cash value growth to a market index, providing potential for growth with some downside protection.

How Cash Value Accumulates

The cash value within a permanent life insurance policy grows through a structured process. When premium payments are made, they are divided into components: one covers the cost of insurance, another accounts for administrative fees, and the remainder is allocated to the cash value.

For whole life policies, the cash value grows at a fixed interest rate, and some participating policies may also earn dividends. These dividends can further enhance cash value or reduce future premiums. Universal life policies accrue cash value based on declared interest rates, which can adjust periodically.

Variable universal life policies accumulate cash value based on the performance of chosen investment sub-accounts. This means growth is tied directly to market fluctuations, offering potential for higher gains or losses. Regardless of the policy type, cash value growth is generally tax-deferred, meaning taxes are not paid on earnings until they are accessed.

Understanding Policy Loans

Policy loans allow a policyholder to borrow money using the accumulated cash value as collateral. The loan is issued by the insurance company, not directly from the cash value itself, which remains intact and continues to grow. There is no credit check or formal approval process, unlike traditional loans.

The amount available for a loan is limited to a percentage of the cash surrender value, often 90% or 95%. Interest is charged on the outstanding loan balance, with rates typically ranging from 5% to 8%, which can be fixed or variable depending on the policy and insurer.

An outstanding policy loan reduces the policy’s death benefit by the loan amount plus any accrued interest if not repaid before the policyholder’s death. However, the policy remains in force as long as premiums are paid and the loan balance does not exceed the cash value.

Tax Considerations for Policy Loans

Policy loans are tax-free because they are treated as debt, not as a withdrawal of policy earnings. The Internal Revenue Service (IRS) views these transactions as a loan from the insurer, secured by the policy’s cash value.

However, a taxable event can occur. If the policy lapses or is surrendered while a loan balance is outstanding, the loan amount that exceeds the policyholder’s basis (total premiums paid) can become taxable income. For example, if premiums paid total $50,000 and the outstanding loan is $60,000, the $10,000 difference may be taxed.

Modified Endowment Contracts (MECs) are another consideration. If a life insurance policy is funded with premiums exceeding certain IRS limits, it can be reclassified as an MEC. Loans from an MEC are treated differently for tax purposes; they are taxed on a “last-in, first-out” (LIFO) basis, meaning any gains are considered withdrawn first and are subject to income tax. Additionally, withdrawals from MECs before age 59½ may incur a 10% federal tax penalty.

Managing Your Policy Loan

Managing a policy loan involves understanding repayment options and long-term impacts. Policy loans offer significant flexibility, as there is no fixed repayment schedule. Policyholders can choose to make regular payments, pay the loan back in a lump sum, or make no repayments.

If the loan is not repaid, interest will continue to accrue. This compounding interest can steadily increase the total amount owed. Over time, an accumulating loan balance can significantly reduce the policy’s cash value and the death benefit.

Allowing the loan balance, including accrued interest, to exceed the policy’s cash value can lead to the policy lapsing. If a policy lapses with an outstanding loan, the loan amount exceeding the cost basis may become a taxable distribution. Consistent monitoring of the loan balance relative to the cash value is advisable to prevent unintended policy termination and potential tax liabilities.