Life Insurance You Can Borrow From Tax-Free

Life insurance policies that accumulate cash value offer a financial tool that extends beyond a traditional death benefit, providing a potential source of funds during the policyholder’s lifetime. The phrase “life insurance you can borrow from tax-free” refers to a specific feature of certain permanent life insurance policies. These policies allow access to accumulated funds, often through loans, which can be received without immediate income tax implications under specific conditions.

Understanding Cash Value Life Insurance

Cash value in a life insurance policy represents a savings component that accumulates over time, separate from the death benefit. A portion of each premium payment contributes to this cash value, which then grows on a tax-deferred basis. This accumulation provides a living benefit that policyholders can access during their lifetime.

Different types of permanent life insurance policies offer this cash value feature. Whole life insurance provides guaranteed cash value growth at a fixed interest rate, along with a guaranteed death benefit and level premiums. Universal life insurance offers lifelong coverage and cash value, provides more flexibility in premium payments and death benefit adjustments, with cash value growth often tied to current interest rates. Variable universal life insurance allows the cash value to be invested in various sub-accounts, similar to mutual funds, with its growth or decline depending on the performance of these underlying investments.

Term life insurance, by contrast, does not include a cash value component. It provides coverage for a specific period, and once the term expires, there is no cash value or payout unless the insured passes away during the policy term. The cash value in permanent policies grows steadily over the years, with the balance increasing as the policy matures and more premiums are paid.

How to Access Cash Value

Policyholders can access their accumulated cash value through two primary methods: policy loans or withdrawals. A policy loan involves borrowing money from the insurer, using the policy’s cash value as collateral. The policy remains in force, and the death benefit is reduced by any outstanding loan amount, including accrued interest.

Withdrawals directly reduce the policy’s cash value and the death benefit permanently. Unlike a loan, a withdrawal is a permanent removal of funds from the policy. While policy loans accrue interest, withdrawals do not, but they reduce the amount available for future loans and the eventual death benefit.

Tax Treatment of Policy Access

Policy loans are considered tax-free because they are treated as a debt against the policy’s cash value, not as income. As long as the policy remains in force, the loan amount is not subject to income tax upon receipt. This tax-free treatment is a significant advantage, allowing policyholders to access funds without immediate tax consequences.

Withdrawals from a cash value policy are tax-free up to the “cost basis,” which is the total amount of premiums paid into the policy. Any amount withdrawn that exceeds this cost basis is considered taxable income, generally taxed as ordinary income.

However, policy loans or withdrawals can become taxable events under specific conditions. If a policy lapses or is surrendered with an outstanding loan balance, the loan amount exceeding the cost basis can become taxable income.

Another consideration is the Modified Endowment Contract (MEC) designation. A policy becomes a MEC if it fails the “7-pay test,” meaning the premiums paid into it exceed certain limits within the first seven years. Once classified as a MEC, all distributions, including loans and withdrawals, are treated first as taxable income to the extent of any gain, and may also be subject to a 10% penalty if taken before age 59½.

Managing Policy Loans

Policy loans accrue interest, which is charged by the insurer at a specified rate. If not paid, this interest is added to the outstanding loan balance, causing it to grow. While policy loans do not have a mandatory repayment schedule, the interest must be managed to prevent the loan from escalating.

Any outstanding loan balance, including accumulated interest, will directly reduce the death benefit paid to beneficiaries upon the policyholder’s passing. Beneficiaries will receive less than the policy’s face amount if a loan has not been repaid.

If a policy loan grows to exceed the accumulated cash value, it can lead to the policy lapsing. When a policy lapses with an outstanding loan, the loan amount that exceeds the premiums paid can become a taxable event. Therefore, monitoring the loan balance and making interest payments, or principal payments, is important to maintain the policy’s integrity and preserve its benefits.