Can I Borrow Money From My Life Insurance?
Explore borrowing options from your life insurance. Understand how policy loans work, their impact, and key considerations for financial flexibility.
Policyholders can access funds from certain life insurance policies through a policy loan. These loans allow borrowing against the accumulated cash value within a permanent life insurance policy. Understanding how these loans operate and their potential implications is important.
Understanding Life Insurance Policy Loans
A life insurance policy loan involves borrowing money from the insurer, with the policy’s accumulated cash value serving as collateral. This differs from a withdrawal, which directly removes funds and permanently reduces the cash value. With a loan, the policy’s cash value remains intact and continues to grow, though the outstanding loan balance affects the amount available.
Only permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life, accumulate cash value and allow for policy loans. Term life insurance does not offer this feature. The cash value component in permanent policies grows over time as a portion of each premium payment is allocated to it, and this accumulated value earns interest or investment returns on a tax-deferred basis. It typically takes several years for sufficient cash value to accumulate before a policy loan becomes a viable option.
Mechanics of a Life Insurance Loan
When considering a life insurance loan, the amount available is determined by the policy’s cash value. Insurers typically permit borrowing up to a percentage of the cash value, commonly around 90%. For example, if a policy has $10,000 in cash value, a policyholder might be able to borrow up to $9,000. The process usually does not require a credit check, as the policy’s cash value itself acts as collateral for the loan.
Interest accrues on the outstanding loan balance, and this interest is paid back to the insurer. The policy’s cash value generally continues to earn interest or dividends even with an outstanding loan, though sometimes at a reduced rate or only on the unborrowed portion. If the insured individual passes away with an outstanding loan, the loan amount, plus any accrued interest, is subtracted from the policy’s death benefit paid to beneficiaries. Furthermore, if the policy lapses or is surrendered while a loan is outstanding, the loan amount that exceeds the policy’s cost basis (the total premiums paid less any dividends received) can become taxable income.
Managing and Repaying Your Policy Loan
Life insurance policy loans offer considerable flexibility regarding repayment. Unlike conventional loans, there are typically no fixed repayment schedules or strict deadlines. Policyholders can choose to make regular payments of principal and/or interest, make lump-sum payments, or even allow the interest to be added to the loan balance.
Despite the flexibility, interest continues to accrue on the unpaid loan balance. If the loan and its accumulating interest are not managed, the growing loan balance can erode the policy’s cash value over time. Should the outstanding loan amount, including accrued interest, eventually exceed the policy’s cash value, the insurance company may terminate the policy. A policy lapse due to an unpaid loan results in the loss of coverage and can trigger adverse tax consequences.
Tax Implications of Policy Loans
Generally, a life insurance policy loan is not considered taxable income when it is taken. This is because the Internal Revenue Service (IRS) views it as an advance against the policy’s cash value, rather than a distribution of gains. The tax-free nature of the loan typically holds as long as the policy remains in force. Interest paid on policy loans is generally not tax-deductible for the policyholder.
However, there are specific situations where a policy loan can become a taxable event. If the life insurance policy lapses or is surrendered while a loan is outstanding, the loan amount exceeding the policy’s cost basis (the premiums paid) becomes taxable income to the policyholder. This is particularly important for policies classified as Modified Endowment Contracts (MECs). Loans taken from MECs are treated differently; they are considered taxable distributions to the extent of any gain in the policy and may be subject to a 10% penalty if the policyholder is under age 59½. A policy becomes a MEC if it fails the “7-pay test,” meaning that premiums paid into the policy during its first seven years exceed certain IRS limits, altering its tax treatment permanently.