Life Insurance You Can Borrow From Immediately

Life insurance policies offer more than a death benefit; some include a savings component that accumulates value. This accumulated value, known as cash value, can be a source of funds accessible to the policyholder during their lifetime. While not immediate upon policy purchase, funds become available once sufficient cash value has grown. These policies differ from those providing coverage without building cash reserves.

Types of Policies That Allow Borrowing

Permanent life insurance policies are the only types that build cash value and allow borrowing. This category includes whole life and universal life insurance. These policies provide lifetime coverage as long as premiums are paid, unlike term life insurance which offers coverage for a set period without cash value.

Whole life insurance offers a guaranteed cash value growth rate and a fixed premium. A portion of each premium contributes to the cash value, which grows predictably. Policyholders may also receive dividends, which can increase cash value or purchase additional coverage.

Universal life insurance provides flexibility, allowing premium and death benefit adjustments. Cash value can grow based on interest rates or investment performance, depending on the specific type of universal life policy.

Understanding Policy Cash Value

Policy cash value is the savings component of a permanent life insurance policy. A portion of each premium is allocated to this value, separate from the death benefit and insurer expenses. It grows over time, typically tax-deferred, with earnings not taxed until withdrawn.

Cash value grows through guaranteed interest rates in whole life policies or interest crediting and investment performance in universal life policies. This accumulated cash value serves as collateral for a policy loan. It typically takes 2 to 10 years to accumulate enough value for a substantial loan.

It is important to distinguish between cash value and cash surrender value. Cash value is the total accumulated amount in the policy’s savings component. Cash surrender value is the amount a policyholder receives upon terminating the policy, typically the cash value minus any surrender fees or outstanding loans. Surrender fees generally decrease the longer a policy is in force.

The Policy Loan Process

Taking a loan against a life insurance policy’s cash value is straightforward, typically requiring no credit check or lengthy approval. Policyholders borrow from the insurer, using the cash value as collateral. Up to 90% of the accumulated cash value can commonly be borrowed. These loans accrue interest, generally 5% to 8%, with rates fixed or variable. While interest accrues, the policy’s cash value may continue to grow through its usual interest or investment gains.

Repayment is flexible, with no mandatory schedule. Policyholders can make payments at their discretion or choose not to repay. However, any outstanding loan balance, including accrued interest, will reduce the death benefit.

A risk arises if the loan balance, with accumulating interest, exceeds the policy’s cash value. This can lead to policy termination and lapse in coverage, eliminating the death benefit and triggering adverse tax consequences.

Tax Implications of Policy Loans

Loans from a life insurance policy are generally not considered taxable income by the IRS. This is because the IRS views these as borrowing against one’s own asset, not a distribution of income. The tax-free status holds as long as the policy remains in force and the loan amount does not exceed total premiums paid.

However, tax liabilities can arise. If a policy lapses or is surrendered with an outstanding loan, the loan amount exceeding premiums paid (the policy’s cost basis) can become taxable income. Any gain, representing cash value growth beyond premiums, becomes subject to ordinary income tax.

Modified Endowment Contracts (MECs) are an additional consideration. A policy becomes an MEC if premium payments exceed certain IRS limits during its first seven years, failing the “seven-pay test.” Loans from an MEC are treated differently for tax purposes; they are taxed on a “last-in, first-out” (LIFO) basis, meaning any gains are taxed first as ordinary income. If the policyholder is under age 59½, these taxable distributions may also be subject to an additional 10% federal penalty. Interest paid on life insurance policy loans is generally not tax-deductible.