Can You Borrow From Your Life Insurance Policy?

A life insurance policy loan enables a policyholder to access funds from their permanent life insurance policy. This mechanism allows individuals to tap into the accumulated value within their policy during their lifetime. Not all life insurance policies offer this borrowing feature. A policy loan involves leveraging the policy’s internal value to secure a loan, rather than withdrawing the funds directly.

Life Insurance Policies Allowing Loans

Policy loans are exclusively available through permanent life insurance policies, which are designed to build cash value over time. These include Whole Life, Universal Life, and Variable Universal Life policies. Whole Life insurance offers a guaranteed cash value growth rate and a fixed premium, providing predictability in its accumulation. Universal Life policies provide flexibility, allowing adjustments to premiums and death benefits, with cash value growth based on the insurer’s declared interest rate. Variable Universal Life policies link cash value growth to investment performance, offering potential for higher returns but also greater risk.

Each of these permanent policy types features a savings component, known as cash value, which accumulates on a tax-deferred basis. This cash value is the foundation for a policy loan, as it serves as the collateral for the borrowed funds. In contrast, term life insurance policies do not accumulate cash value. Consequently, term life policies do not offer any loan provisions, as there is no underlying savings component to borrow against.

Understanding Policy Loans

A life insurance policy loan is not a direct withdrawal from the policy’s cash value. Instead, it is a loan issued by the insurer, with the policy’s cash value serving as collateral. The policy itself remains active and in force, continuing to accumulate cash value and potentially earn dividends, even with an outstanding loan. This means the policy’s benefits, including the death benefit, generally remain intact, although they are affected by the loan balance.

The amount of an outstanding loan, including any accrued interest, directly reduces the death benefit paid to beneficiaries if the loan is not repaid before the insured’s passing. Interest accrues on the loan balance, typically at a variable rate. Policyholders generally have flexibility in repaying this interest, or they can allow it to be added to the outstanding loan balance. A notable feature of these loans is that they usually do not require a credit check, as the loan is secured by the policy’s own value.

Obtaining and Managing a Policy Loan

Accessing a life insurance policy loan typically involves a straightforward process. Policyholders usually initiate the request by contacting their insurance company. The insurer will then provide the necessary forms or instructions for completing the loan application. Once the paperwork is submitted and processed, the funds are disbursed to the policyholder.

Managing a policy loan involves understanding the flexible repayment options. Policyholders can choose to repay both the principal and interest, or they may opt to pay only the interest. Alternatively, the accrued interest can be added to the outstanding loan balance, increasing the total amount owed.

However, allowing the loan balance to grow unchecked carries a significant risk. If the total outstanding loan balance, including accrued interest, eventually exceeds the policy’s cash value, the policy can lapse. In such a scenario, the policy terminates, and the outstanding loan amount may become subject to taxation.

Tax Treatment of Policy Loans

Generally, life insurance policy loans are not considered taxable income when they are taken out. This is because the Internal Revenue Service (IRS) treats these transactions as debt rather than as a distribution of income. The policy’s cash value acts as collateral, and the funds received are viewed as a loan that must eventually be repaid, either by the policyholder or from the death benefit.

However, there is a significant exception for policies classified as Modified Endowment Contracts (MECs). 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 specific IRS limits. Loans from MECs are treated differently for tax purposes; they are considered distributions and are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are taxed first. Furthermore, if the policyholder is under age 59½, these distributions may be subject to a 10% federal penalty tax in addition to regular income tax.

If a life insurance policy with an outstanding loan lapses or is surrendered, the unpaid loan amount, up to the amount of gain in the policy, can become taxable income to the policyholder. This is because the IRS views the repayment of the loan from the policy’s cash value as a constructive distribution of previously untaxed gains. Policy loan interest is a cost associated with borrowing, but it is generally not tax-deductible for the policyholder.