Can You Borrow From Supplemental Life Insurance?

Supplemental life insurance provides additional coverage beyond a primary policy, whether employer-provided or independently purchased. It offers extra financial protection for beneficiaries, supplementing existing plans that may not fully meet an individual’s needs. This coverage enhances security for loved ones in the event of an unexpected loss.

Understanding Supplemental Life Insurance and Loan Eligibility

Supplemental life insurance broadly falls into two main categories: term life and permanent life. Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years, and typically does not build any cash value. If the policyholder outlives the term, the coverage ends without any accumulated savings. Therefore, supplemental term life insurance policies cannot be borrowed against because they lack a savings component.

In contrast, permanent life insurance policies, such as whole life, universal life, and variable universal life, are designed to provide coverage for the policyholder’s entire life. These policies include a cash value component, which grows over time. A portion of the premiums paid into a permanent policy contributes to this cash value, alongside the death benefit. This cash value growth is typically tax-deferred.

The cash value in a permanent life insurance policy grows through premium payments, interest, or investment returns, depending on the policy type. Whole life policies, for example, often offer a guaranteed interest rate, while universal life policies tie growth to declared rates and provide more flexibility.

Only supplemental life insurance policies with sufficient cash value are eligible for loans. The cash value must reach a certain level before it can be accessed, which typically takes several years from the policy’s inception.

The Mechanics of a Policy Loan

When borrowing from an eligible supplemental life insurance policy, the accumulated cash value acts as collateral. This simplifies the borrowing process, as there is typically no need for a credit check, income verification, or a lengthy application, since the policyholder is essentially borrowing their own money.

The process for requesting a loan is generally straightforward, often involving contacting the insurer and submitting a request form. Funds are usually disbursed within a few days of the request. The maximum loan amount available is typically a percentage of the policy’s cash surrender value, commonly ranging from 90% to 95%.

Interest rates on policy loans can be either fixed or variable, depending on the specific policy contract and insurer. These rates are generally competitive and often lower than those for personal loans or credit cards, typically ranging from 5% to 8%. The interest charged on the loan goes back to the insurance company.

Policy loan proceeds are generally not considered taxable income, as the Internal Revenue Service (IRS) views them as an advance against the policy’s cash value, not income. This tax-free status holds true as long as the policy remains in force and is not a Modified Endowment Contract (MEC). If classified as an MEC, loans may be taxable to the extent of any gain, and withdrawals before age 59½ could incur an additional 10% penalty.

Policy loans offer considerable flexibility regarding repayment. There is typically no fixed repayment schedule, allowing policyholders to repay the loan at their own pace, or even not at all. However, interest accrues on the outstanding loan balance, and if this interest is not paid, it will be added to the loan principal, causing the total amount owed to increase over time. Interest paid on policy loans for personal use is generally not tax-deductible.

Implications of Policy Loans

An outstanding policy loan directly reduces the death benefit payable to beneficiaries. The loan amount, plus any accrued and unpaid interest, will be subtracted from the death benefit when the policyholder passes away.

The portion of the cash value used as collateral for the loan may experience a reduced rate of interest or dividends, or cease to earn interest. This practice, known as “direct recognition,” means the loaned amount does not continue to compound at the same rate as the unloaned cash value. This can slow the overall growth of the policy’s cash value.

Unpaid loan interest is typically added to the outstanding loan principal, leading to a growing loan balance. If the total outstanding loan balance, including accrued interest, exceeds the policy’s cash value, the policy can be at risk of lapsing.

A policy lapse due to an excessive loan balance can have significant financial consequences. When a policy lapses with an outstanding loan, the unpaid loan amount may be considered a taxable distribution by the IRS, potentially leading to an unexpected tax liability for the policyholder. This tax liability can arise even if the policyholder does not receive any net cash from the policy.

Policyholders have options for managing an outstanding loan. They can make partial payments, repay the loan in full, or allow the loan balance to be subtracted from the death benefit upon their passing. Regular monitoring of the loan balance in relation to the cash value is important to avoid unintended consequences and ensure the policy remains in force.