Can You Borrow Against Supplemental Life Insurance?

Supplemental life insurance provides an additional layer of financial protection, often acquired through an employer or purchased independently. A common question arises regarding these policies: how policyholders can access their accumulated value. This article explores methods for utilizing the value in supplemental life insurance policies, particularly focusing on borrowing against them.

Understanding Cash Value in Supplemental Policies

Cash value is a component within certain types of life insurance policies that accumulates over time, functioning as a savings or investment element. This accumulated value can be accessed by the policyholder during their lifetime. A portion of the premiums paid into these policies is allocated to this cash value account, alongside funds covering the death benefit and administrative costs. The rate at which cash value grows varies depending on the specific policy type.

Whole life insurance policies, a common form of permanent coverage, build cash value at a guaranteed interest rate, offering stable accumulation. Universal life insurance policies also accumulate cash value, with growth often linked to current interest rates, though they include a guaranteed minimum rate. Policyholders may have flexibility in adjusting premium payments.

Variable universal life insurance, another permanent option, allows the cash value to be invested in various subaccounts, similar to mutual funds. The growth of this cash value is tied to the performance of these chosen investments, offering potential for higher returns but also carrying market risk. Interest and earnings on cash value in these permanent policy types grow on a tax-deferred basis, meaning taxes are not paid on the growth until the funds are accessed.

In contrast, term life insurance policies do not accumulate cash value. Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years, and offers a death benefit if the insured passes away within that term. Because they lack a cash value component, term policies are more affordable than permanent life insurance, focusing solely on death benefit protection. Borrowing against a term life insurance policy is not possible as there is no cash value to leverage.

How Policy Loans Operate

A policy loan allows a policyholder to borrow money using the accumulated cash value of a permanent life insurance policy as collateral. This is distinct from a traditional loan from a bank or other financial institution. The insurance company provides an advance against the policy’s death benefit, and there is no credit check or extensive application process. Insurers allow borrowing up to 90% or 95% of the policy’s cash surrender value.

Interest accrues on the outstanding loan balance, and rates can be either fixed or variable, ranging from 5% to 8%. This interest is paid back to the policy, not to an external lender. The cash value of the policy continues to earn interest, even while the loan is outstanding, though net growth may be reduced. Policy loans offer flexibility in repayment; there is no mandatory repayment schedule, and the policyholder can choose to repay the loan at their convenience, or not at all.

However, if the loan, including accrued interest, is not repaid, it will reduce the death benefit paid to beneficiaries. An outstanding loan can also lead to a policy lapse if the total loan amount, plus interest, exceeds the policy’s cash value. Should the policy lapse with an unpaid loan, the outstanding loan amount that exceeds the premiums paid into the policy may become taxable income to the policyholder. Policy loans are not considered taxable income as long as the policy remains in force, as the IRS views them as an advance rather than income. Interest paid on policy loans is not tax-deductible for personal use.

Other Methods for Accessing Policy Value

Beyond policy loans, policyholders can access the accumulated cash value within their supplemental life insurance policies through other methods. These methods differ in their impact on the policy’s future benefits and tax implications. Alternatives include cash value withdrawals and surrendering the policy.

Cash value withdrawals involve directly taking money out of the policy’s accumulated value. Unlike a loan, a withdrawal permanently reduces both the policy’s cash value and its death benefit. The amount withdrawn is tax-free up to the total amount of premiums paid into the policy. Any amount withdrawn that exceeds the total premiums paid will be subject to income tax. Some policies, particularly universal life, may allow for withdrawals, but these directly deplete the cash available for future growth and can impact the policy’s ability to remain in force if not managed carefully.

Alternatively, a policyholder can surrender the policy entirely. Surrendering means terminating the life insurance coverage in exchange for the policy’s cash surrender value. This action results in the cessation of all coverage and benefits. The tax implications of surrendering a policy are similar to withdrawals: any amount received up to the total premiums paid is tax-free. If the cash surrender value received exceeds the total premiums paid, that excess amount is considered a taxable gain.

Surrender charges may also apply, particularly if the policy is terminated early, further reducing the amount received. These methods offer direct access to funds but fundamentally alter or end the insurance contract, unlike a policy loan which maintains the policy’s in-force status with the cash value acting as collateral.