Can You Take a Loan Out of Your Life Insurance?

Life insurance policies can offer more than just a death benefit for beneficiaries; certain types can also serve as a financial resource during the policyholder’s lifetime. This access to funds often comes in the form of a policy loan, allowing individuals to leverage the accumulated value within their insurance. Understanding how these loans function and their implications is important for anyone considering this option.

Understanding Life Insurance Loans

A life insurance loan represents an advance taken against the cash value that has accumulated within a permanent life insurance policy, rather than a traditional loan from an external lender. The policy itself acts as collateral. Cash value builds over time as a portion of premiums paid is allocated to a separate account, which then grows through interest or investment returns. This accumulation occurs on a tax-deferred basis.

Only permanent life insurance policies, such as whole life, universal life, variable universal life, and indexed universal life, develop this cash value component that can be borrowed against. Whole life policies typically offer guaranteed cash value growth at a fixed rate, providing predictability. Universal life policies offer more flexibility in premiums and death benefits, with cash value growth often tied to current interest rates. Variable universal life policies allow the cash value to be invested in sub-accounts, which can offer higher growth potential but also carry investment risk.

In contrast, term life insurance policies are designed to provide coverage for a specific period and do not build cash value, meaning they do not offer the option for policy loans. The ability to access accumulated cash value through a loan is a defining feature of permanent life insurance, providing a potential source of liquidity not available with term policies.

The Mechanics of Taking a Loan

When a policyholder takes a loan from their life insurance, the policy’s cash value serves as the collateral for the borrowed amount. This means the loan is secured by the policy’s own value, which can result in more favorable loan terms compared to unsecured personal loans. The maximum amount an individual can borrow is typically a percentage of the accumulated cash value, often ranging up to 90%. It can take several years for a policy to build sufficient cash value to make a loan feasible, depending on the policy type and premium payments.

Interest rates are applied to policy loans, which can be either fixed or variable, depending on the terms set by the insurer. These rates are generally competitive, often falling within a range of 5% to 8%, which can be lower than rates for personal loans or credit cards. Interest accrues on the outstanding loan balance. While the cash value continues to grow even with an outstanding loan, the policy’s dividends might be reduced.

If the loan, including any accrued interest, is not fully repaid before the insured’s passing, the outstanding balance will be deducted from the death benefit amount. If the outstanding loan balance plus accrued interest grows to exceed the policy’s cash value, the policy could lapse, resulting in a loss of coverage and tax implications.

The Loan Application and Management Process

Accessing a life insurance policy loan typically involves a straightforward process, often initiated by contacting the insurance provider. Policyholders can usually request a loan through various channels, such as customer service, a request form, or an online portal. The process generally does not require a credit check or lengthy approval, as the loan is secured by the policy’s cash value.

For the application, policyholders generally need to provide their policy number, desired loan amount, and sign necessary forms. Once the request is processed, funds are typically disbursed through direct deposit or a check. Policy loans offer flexible repayment options, often with no fixed schedule, allowing policyholders to repay at their own pace or pay only the interest.

Managing an outstanding policy loan is important to maintain the policy’s integrity. An unpaid loan and its accrued interest will be subtracted from the death benefit upon the insured’s death, reducing the payout to beneficiaries. A significant risk arises if the accumulating loan balance, including interest, exceeds the policy’s cash value, which can lead to policy lapse, loss of coverage, and a taxable event. Monitoring the loan balance relative to the cash value and making at least interest payments is advisable to prevent a policy lapse.

Tax and Policy Considerations

Policy loans from life insurance are generally not considered taxable income, provided the policy remains in force. This tax-advantaged status stems from the fact that the money is treated as a loan against the policy’s cash value, not a withdrawal of earnings. The Internal Revenue Service (IRS) generally views these as a debt against the policy. As long as the policy is active and not surrendered or allowed to lapse, loan proceeds typically avoid taxation.

However, there are specific situations where a policy loan can trigger a tax liability. If the policy lapses or is surrendered while an outstanding loan exists, the loan amount, to the extent it exceeds the premiums paid into the policy (known as the cost basis), can become taxable as ordinary income. For example, if a policy with a cash value of $150,000 and total premiums paid of $80,000 lapses with a $100,000 loan, the policyholder could face taxation on the $70,000 gain ($150,000 cash value – $80,000 premiums paid), as the loan is treated as a distribution. This tax bill can be substantial.

Another situation that impacts the tax treatment of policy loans is if the life insurance policy is classified as a Modified Endowment Contract (MEC). For MECs, loans and withdrawals are taxed on a “last-in, first-out” (LIFO) basis, meaning any earnings are considered to be distributed first and are immediately taxable. If the policyholder is under age 59½, a 10% penalty may apply to the taxable portion of the loan, similar to penalties on early retirement account withdrawals. Monitoring the policy’s cash value and outstanding loan balance is important to prevent tax consequences and ensure the policy remains active.