Can You Borrow From Voluntary Life Insurance?

Voluntary life insurance is an optional financial protection plan often offered by employers, providing a cash benefit to beneficiaries upon the death of the insured. This type of coverage allows individuals to supplement basic employer-provided benefits or secure protection if they lack other options.

Types of Voluntary Life Insurance and Cash Value

Life insurance policies generally fall 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 cash value. Conversely, permanent life insurance policies, like whole life, universal life, variable universal life, and indexed universal life, offer lifelong coverage and include a savings or investment component known as cash value.

Cash value represents a portion of the premiums paid that accumulates over time on a tax-deferred basis within the policy. This accumulated value can be accessed by the policyholder during their lifetime. While “voluntary life insurance” can refer to employer-sponsored plans, the capacity to borrow is directly linked to this cash value feature, which is predominantly found in individually-owned permanent policies, even if such policies are offered as an option through an employer. Most group life insurance plans provided by employers are term life policies, which typically do not have a cash value component from which to borrow.

Voluntary whole life insurance, however, is a type of permanent life insurance that can be offered through an employer and does build cash value. This cash value grows steadily over the policy’s lifespan, and it can be a source of funds for the policyholder.

Process of Taking a Policy Loan

Taking a loan from a life insurance policy differs significantly from obtaining a traditional bank loan. When you borrow from a permanent life insurance policy, you are essentially borrowing against the accumulated cash value, which serves as collateral for the loan. The cash value itself remains within the policy, continuing to grow, while the insurer lends you funds from their general account. The loan does not reduce the policy’s cash value directly but rather uses it as security.

The process to obtain a policy loan is generally straightforward, requiring no credit checks or extensive approval procedures. Policyholders typically need to contact their insurance company to verify their policy’s loan eligibility and the maximum available loan amount, which is often up to 90% or 95% of the accumulated cash value. After confirming eligibility, the policyholder completes the necessary forms, and the funds are usually disbursed within a few days to a few weeks. It can take several years for a policy to build sufficient cash value to allow for a meaningful loan.

Interest accrues on the policy loan, with rates typically ranging from 5% to 8%, which can be fixed or variable depending on the policy terms and the insurer. Managing the interest payments is important to prevent the loan from negatively impacting the policy’s long-term health.

Understanding Loan Repayment and Policy Impact

Life insurance policy loans offer considerable flexibility regarding repayment, unlike conventional loans that adhere to strict schedules. Policyholders are not typically required to follow a fixed repayment schedule, and they can choose to repay the principal and interest at their discretion, pay only the interest, or even make no payments at all. However, interest continues to accrue on the outstanding loan balance, increasing the total amount owed.

An outstanding loan, including any accrued interest, will directly reduce the death benefit paid to beneficiaries. If the policyholder passes away before the loan is fully repaid, the insurance company will deduct the outstanding balance from the death benefit, resulting in a smaller payout to the beneficiaries.

A significant risk associated with policy loans is the potential for policy lapse. If the outstanding loan balance, compounded by accrued interest, grows to exceed the policy’s cash value, the policy may terminate.

Furthermore, there can be adverse tax implications if a policy lapses with an outstanding loan. While policy loans are generally tax-free as long as the policy remains in force and the loan amount does not exceed the premiums paid into the policy, a lapse can trigger a taxable event. The outstanding loan amount, to the extent it exceeds the policy’s cost basis (total premiums paid), may be treated as taxable income by the Internal Revenue Service (IRS). For certain policies classified as Modified Endowment Contracts (MECs), loans are treated differently, with earnings potentially being taxed first and subject to a 10% penalty if the policyholder is under age 59½.