What Is Life Insurance You Can Borrow From?

Life insurance policies can offer a benefit beyond a death payout: the ability to access accumulated funds while the policyholder is still living. This feature is tied to policies that develop a cash value component, which grows over time. Policyholders can potentially borrow against a portion of that accumulated value.

Types of Policies that Allow Borrowing

Certain types of life insurance policies are designed to build cash value, which then becomes available for the policyholder to access. These are generally referred to as permanent life insurance policies. The two primary categories that offer this feature are Whole Life insurance and Universal Life insurance.

Whole Life insurance policies accumulate cash value at a guaranteed rate, providing a predictable growth trajectory. A portion of each premium payment is allocated to this cash value account. Some whole life policies may also pay dividends, which can further increase the cash value.

Universal Life insurance policies offer more flexibility in premium payments and death benefits, and their cash value growth is tied to interest rates or market performance. This cash value component grows based on interest rates set by the insurer or linked to a market index, though usually with a guaranteed minimum rate.

Understanding Policy Loans

A policy loan involves borrowing money directly from the insurance company, using the policy’s accumulated cash value as collateral. The funds for the loan come from the insurer’s general account, not directly from the cash value itself. This means the cash value typically remains intact within the policy, continuing to earn interest or dividends.

Interest is charged on the outstanding loan balance. This interest rate can be either fixed or variable. If the interest is not paid, it will accrue and be added to the principal balance of the loan, causing the overall loan amount to grow.

Policy loans offer flexibility regarding repayment, as there is no fixed schedule for principal repayment. Policyholders can choose to repay the loan gradually, in a lump sum, or not at all while the policy remains in force. However, any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries.

The portion of the cash value used as collateral for a loan may be subject to different interest or dividend crediting rates, depending on the insurer’s policy. The loaned portion of the cash value may earn a different, potentially lower, dividend rate than the unencumbered cash value. This can influence the overall growth of the policy’s cash value, although the principal amount of the cash value typically continues to grow. If the loan balance, including interest, grows to exceed the policy’s cash value, the policy can lapse, leading to a loss of coverage and potential tax implications.

Distinguishing Policy Loans from Withdrawals

Accessing funds from a life insurance policy with cash value can be done through either a policy loan or a direct cash value withdrawal.

A policy loan is a transaction where the policyholder borrows money from the insurer, with the policy’s cash value acting as collateral. Since it is a loan, it accrues interest, which must be managed to prevent the loan balance from growing excessively. Repayment of the loan is flexible, and the cash value generally remains within the policy, continuing to grow, though its growth rate might be affected. If the loan is not repaid by the time the insured passes away, the outstanding balance is subtracted from the death benefit.

In contrast, a cash value withdrawal involves the direct and permanent removal of funds from the policy’s accumulated cash value. This action does not create a debt, so there is no interest charged and no repayment is required. However, a withdrawal directly and permanently reduces the policy’s cash value and, consequently, its death benefit. The withdrawn amount is no longer part of the policy and therefore cannot continue to grow within it.

Tax Implications of Policy Loans

Policy loans are generally not considered taxable income when they are taken, as they are viewed by the Internal Revenue Service (IRS) as debt rather than a distribution of gains. This tax-free treatment holds true as long as the life insurance policy remains in force.

However, a policy loan can become taxable if the policy lapses or is surrendered with an outstanding loan balance. In such cases, if the loan amount exceeds the total premiums paid into the policy (known as the cost basis), the difference may be treated as taxable income. This occurs because the loan is then no longer secured by a living policy.

A specific circumstance that alters the tax treatment of policy loans is if the life insurance contract is classified as a Modified Endowment Contract (MEC). A policy becomes an MEC if the premiums paid exceed certain IRS limits within the first seven years of the policy, failing the “7-pay test.” For MECs, loans are treated differently; they are considered distributions and are taxed on a “gain first” basis. Any taxable gain from a loan on an MEC may also be subject to a 10% federal penalty if the policyholder is under age 59½.