Can You Take Out a Loan on Life Insurance?

Life insurance functions as a financial agreement between an individual and an insurer, offering protection for loved ones. The policyholder pays regular premiums to the insurance company. In return, the insurer commits to delivering a predetermined sum, a death benefit, to beneficiaries upon the policyholder’s death. This arrangement provides financial security, helping families with expenses like funeral costs, outstanding debts, or continued income for dependents.

What a Life Insurance Policy Loan Is

Not all life insurance policies permit policyholders to take out loans; this feature is specifically available with policies that accumulate cash value over time. These typically include permanent life insurance products like whole life, universal life, and variable universal life policies. Term life insurance policies do not offer this loan feature because they lack a cash value component. The cash value within these permanent policies grows from a portion of the premium payments and potential investment returns, creating a savings element that can be accessed during the policyholder’s lifetime.

A policy loan is not a direct withdrawal from this accumulated cash value but rather a loan taken against it, with the cash value serving as collateral. The insurance company itself provides the loan, not a third-party lender, which means there is typically no credit check or extensive application process involved.

The amount available for a loan is generally a percentage of the cash value, with the policy’s terms determining the exact amount. It can take several years for sufficient cash value to build within a policy before a significant loan can be accessed. While the loan is outstanding, the cash value continues to accrue interest or investment gains, although it remains pledged as collateral. This structure allows policyholders to access funds without fully surrendering their policy or disrupting its long-term growth potential.

Taking Out and Managing a Policy Loan

Accessing a life insurance policy loan typically involves a direct request to the insurance company. Policyholders contact their insurer to initiate the process. The process is usually streamlined because the loan is secured by the policy’s own value.

Once approved, interest begins to accrue on the outstanding loan balance. The interest rate for policy loans can be either fixed or variable, as determined by the specific policy contract. These interest payments are generally not tax-deductible for the policyholder. Policyholders typically have considerable flexibility in repaying the loan; there are often no strict repayment schedules, and individuals can choose to repay the principal and interest at their own pace, or even opt not to repay it at all during their lifetime.

An outstanding policy loan, along with any accrued interest, directly reduces the death benefit payable to beneficiaries. If the policyholder passes away with an unpaid loan, the insurance company will deduct the total outstanding amount from the death benefit before distributing the remaining funds to the beneficiaries.

A significant risk associated with policy loans is the possibility of policy lapse. If the outstanding loan balance, including accrued interest, grows to exceed the accumulated cash value, the policy can terminate, potentially leading to adverse tax consequences and loss of coverage.

Tax Implications of Policy Loans

Life insurance policy loans are generally treated as tax-free transactions, provided the policy remains active and in force. This tax-favored status arises because the loan is considered an advance against the policy’s cash value, rather than taxable income.

However, a policy loan can become a taxable event under specific circumstances. If the policy lapses or is surrendered with an outstanding loan balance, the amount of the loan exceeding the premiums paid into the policy (known as the cost basis) can be considered taxable income. This occurs because the IRS views the loan as a distribution that was not repaid, making the portion above the policyholder’s investment taxable gain.

Modified Endowment Contracts (MECs) have different tax rules regarding policy loans. A life insurance policy becomes an MEC if it fails the “7-pay test,” meaning cumulative premiums paid during the first seven years exceed a specified limit. Loans taken from an MEC are subject to “last-in, first-out” (LIFO) taxation, where distributions are first considered taxable gain. If the policyholder is under age 59½, loans from an MEC may also be subject to an additional 10% penalty tax on the taxable portion.

For beneficiaries, the tax treatment of the death benefit remains largely unchanged, even with an outstanding loan. The death benefit, after the loan and any accrued interest have been deducted, is generally received by beneficiaries free of federal income tax. The reduction in the death benefit amount due to the loan does not alter its tax-exempt status for the recipients. This ensures that the remaining proceeds provide tax-efficient financial support to the designated individuals.