What Life Insurance Can You Borrow From?

Life insurance policies can provide financial protection for beneficiaries after an insured’s passing. Certain types of these policies also offer a living benefit through an accumulating cash value, which policyholders can access during their lifetime. This cash value component allows for various options, including the ability to borrow funds directly from the policy. Understanding how this borrowing mechanism works and its potential implications is important for policyholders considering this financial tool.

Policies with Cash Value

Not all life insurance policies build cash value; only permanent life insurance policies include this feature. These policies are designed to provide coverage for the insured’s entire life, assuming premiums are paid. A portion of each premium payment contributes to the policy’s cash value, which grows over time on a tax-deferred basis.

Whole life insurance is a type of permanent policy that offers guaranteed cash value growth at a steady rate. Universal life insurance provides more flexibility, allowing policyholders to adjust premiums and death benefits. Its cash value growth is tied to an interest rate declared by the insurer, offering a flexible accumulation.

Variable universal life insurance also offers flexibility but includes an investment component. The cash value in these policies fluctuates based on the performance of underlying investment sub-accounts. Conversely, term life insurance policies do not accumulate cash value because they provide coverage for a specific period, typically 10, 20, or 30 years.

Understanding Policy Loans

A policy loan functions as an advance from the insurer, using the policy’s cash value as collateral. The cash value itself remains intact and continues to grow, though the portion securing the loan may have its growth rate adjusted.

One notable aspect of these loans is that they do not require a credit check or application processes. The loan is secured by the policy’s own cash value. Insurers allow borrowing up to a certain percentage of the accumulated cash value, often ranging from 90% to 95%.

Interest is charged on the borrowed amount, with rates ranging from 5% to 8%, which can be fixed or variable. This interest accrues on the outstanding loan balance. Repayment of a policy loan is flexible, with no mandatory schedule, but interest payments are expected. If interest is not paid, it can be added to the outstanding loan balance, causing the total debt to increase.

Impact on Policy and Beneficiaries

Taking a loan from a life insurance policy can have several consequences for the policy and its beneficiaries. A primary impact is the reduction of the death benefit. Any outstanding loan balance, including accrued interest, will be deducted from the death benefit paid to beneficiaries upon the insured’s passing.

The portion of the cash value used as collateral for the loan may not continue to earn interest or dividends at the same rate as the unencumbered portion. This can slow the overall growth of the policy’s cash value over time. While the cash value continues to accrue interest, the net effect of the loan can diminish the policy’s long-term accumulation potential.

Policy loans carry the risk of policy lapse. If the loan balance, including accumulated interest, grows to exceed the policy’s cash value, or if required interest payments are not made, the insurer may terminate the coverage. This results in the loss of the death benefit and potentially adverse tax consequences. In some situations, a lapsed policy might be reinstated, but this requires repayment of the outstanding loan and accrued interest, along with any missed premiums.

Tax Treatment

Policy loans are not considered taxable income as long as the policy remains in force. The Internal Revenue Service (IRS) views these funds as a loan against an asset rather than a distribution of income. This tax-free status benefits policyholders seeking to access funds without incurring immediate tax liabilities.

However, the tax treatment changes if the policy lapses or is surrendered with an outstanding loan. In such cases, the amount of the loan that exceeds the total premiums paid into the policy (the cost basis) can become taxable income. This gain represents the policy’s earnings, which were tax-deferred until the policy’s termination. The insurer issues a Form 1099-R for this taxable event.

If a life insurance policy is classified as a Modified Endowment Contract (MEC), tax treatment differs. A policy becomes a MEC if it is overfunded, meaning the premiums paid exceed certain IRS limits within the first seven years, as defined by the “seven-pay test” under Internal Revenue Code Section 7702A. Loans from a MEC are treated as distributions of income first, rather than a return of premiums. These distributions may be subject to income tax and, if taken before age 59½, an additional 10% penalty, similar to withdrawals from annuities.