What Is an Insurance Policy You Can Borrow Against?

An insurance policy that allows borrowing against it is typically a permanent life insurance policy with a cash value component. This cash value accumulates over time from premiums paid. Policyholders can access this cash value during their lifetime, often through loans, providing funds for various financial needs. This feature distinguishes permanent life insurance from term life insurance, which only provides a death benefit for a specific period and does not build cash value. These policies offer both a death benefit for beneficiaries and a living benefit for the policyholder.

Identifying Insurance Policies with Cash Value

Permanent life insurance policies include a savings component known as cash value. This cash value grows over time on a tax-deferred basis, with earnings untaxed until accessed. Three primary types of permanent life insurance policies accumulate cash value: Whole Life, Universal Life, and Variable Universal Life. Each type accumulates cash value differently.

Whole Life Insurance policies offer a guaranteed fixed interest rate for cash value growth, making them a stable and predictable option. A portion of each premium payment is allocated to this cash value, which can increase faster if dividends are reinvested. Universal Life Insurance policies provide flexibility, with cash value growth tied to current interest rates set by the insurer, often with a guaranteed minimum rate. Policyholders can adjust premiums and death benefits within limits, with excess premiums contributing to cash value. Variable Universal Life Insurance policies allow policyholders to invest the cash value in various sub-accounts, similar to mutual funds, offering potential for higher returns but also greater risk based on market performance. The cash value and death benefit can fluctuate with market conditions in these policies.

The Process of Taking a Policy Loan

Taking a loan from a life insurance policy means borrowing money directly from the insurance company, using the policy’s cash value as collateral. The loan amount is typically limited to a percentage of the cash value, often up to 90% or 95%. There is no credit check or extensive application process required, making it a readily accessible source of funds.

The loan accrues interest, charged by the insurer, ranging from approximately 5% to 8%. Policyholders have flexibility regarding repayment; there is no fixed repayment schedule, and they can choose to repay the principal and interest, pay only the interest, or not repay the loan at all during their lifetime. However, any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries upon the insured’s passing. If the loan balance, with accumulated interest, grows to exceed the policy’s cash value, the policy can lapse, leading to a loss of coverage and potential tax consequences.

Tax Implications of Policy Loans

Policy loans are generally not considered taxable income when taken, as the IRS views them as an advance against the policy’s cash value rather than a distribution of earnings. This tax-free status holds true as long as the policy remains in force and does not lapse or get surrendered. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount, up to the policy’s gain (cash value exceeding premiums paid), can become taxable income.

An exception to the tax-free rule for policy loans involves Modified Endowment Contracts (MECs). A life insurance policy becomes an MEC if premiums paid exceed IRS limits within the first seven years, failing the “7-pay test”. Loans from an MEC are treated differently for tax purposes; they are subject to “last-in, first-out” (LIFO) taxation, meaning any gains are considered withdrawn first and are immediately taxable as ordinary income. If the policyholder is under age 59½, MEC loans may also incur a 10% federal penalty tax on the taxable portion. Interest paid on policy loans is generally not tax-deductible, unless the loan proceeds are used for specific business or investment purposes.

Policy Loans vs. Withdrawals

Distinguishing between a policy loan and a withdrawal from a life insurance policy’s cash value is important due to their different impacts and tax treatments. A policy loan is a borrowing against the cash value, using it as collateral, while the cash value remains within the policy and continues to grow. It accrues interest, and if not repaid, the outstanding balance reduces the death benefit. The loan is generally not taxed unless the policy lapses or is surrendered with an unpaid balance.

Conversely, a withdrawal directly removes funds from the policy’s cash value, permanently reducing the cash value and the policy’s death benefit. For tax purposes, withdrawals are generally tax-free up to the amount of premiums paid into the policy (the cost basis). However, any portion exceeding the cost basis is considered taxable income. If the policy is an MEC, all withdrawals are taxed on a LIFO basis, meaning gains are taxed first, and may incur a 10% penalty if taken before age 59½.