What Type of Life Insurance Policy Can I Borrow From?

Life insurance policies can offer more than a death benefit; certain types allow policyholders to access a portion of the policy’s value during their lifetime. This capability stems from cash value, which accumulates over time within the policy. Understanding how this cash value works is important for those considering accessing funds from their life insurance. This article will explore the types of life insurance policies that build cash value and how policy loans operate.

Understanding Cash Value Life Insurance

Cash value life insurance refers to policies that accumulate a savings component alongside the traditional death benefit. This cash value grows over time, separate from the death benefit paid to beneficiaries. A portion of each premium payment contributes to this cash value, which then grows on a tax-deferred basis, often through interest accrual or investment returns. The accumulated cash value in these policies serves as collateral for a policy loan.

Whole life insurance is a permanent policy where cash value grows at a guaranteed rate and remains level. Universal life insurance offers flexibility, allowing adjustments to premiums and death benefits, with cash value growth tied to an insurer-set interest rate. Variable universal life insurance links cash value growth to underlying investment sub-accounts, introducing higher potential returns and greater risk.

How Policy Loans Operate

A policy loan allows a policyholder to borrow funds directly from the life insurance company, using the policy’s accumulated cash value as collateral. This is not a withdrawal of the cash value itself, but a loan against it, meaning the cash value continues to grow within the policy. The maximum loan amount is a percentage of the policy’s cash surrender value, usually 90% to 95%.

The interest rate on policy loans can be fixed or variable, with rates varying among insurers and policy types, typically 5% to 8% annually. This interest accrues on the outstanding loan balance, similar to a traditional loan. Policy loans offer flexible repayment terms; there is no mandatory schedule, and policyholders can choose to repay at their convenience or not at all. Interest continues to accumulate on the outstanding balance, and any unpaid interest is added to the principal. Since the policy’s cash value acts as collateral, policy loans do not require a credit check or extensive application. This makes them a readily accessible source of funds.

Consequences of Outstanding Policy Loans

An outstanding policy loan, including any accrued interest, directly reduces the death benefit paid to beneficiaries. For example, if a policy has a $500,000 death benefit and a $50,000 outstanding loan, beneficiaries would receive $450,000. This reduction occurs because the loan is repaid from the death benefit proceeds before distribution.

A risk associated with outstanding policy loans is the potential for policy lapse. If the outstanding loan balance, combined with accrued interest, grows to exceed the policy’s cash value, the policy can terminate, especially if premium payments are discontinued. The policy might also lapse if the cash value is insufficient to cover ongoing policy charges and loan interest.

When a policy lapses with an outstanding loan, it can trigger a taxable event, as the previously untaxed loan amount may become taxable income. For policies that pay dividends, an outstanding loan might impact the amount of dividends earned or their allocation. Policyholders should regularly review their policy statements to monitor their loan balance and cash value to prevent unintended consequences.

Tax Considerations for Policy Loans

Policy loans are tax-free income as long as the life insurance policy remains in force. This means the funds received from a policy loan are not subject to income tax at the time the loan is taken. The tax-free nature of policy loans is an advantage, providing liquidity without immediate tax implications.

However, a policy loan can become a taxable event if the policy lapses or is surrendered with an outstanding loan balance. In such cases, the outstanding loan amount, up to the policy’s gain (the amount by which cash value exceeds premiums paid), is treated as taxable income. This occurs because the loan is no longer secured by a tax-deferred asset.

Life insurance policies classified as Modified Endowment Contracts (MECs) have specific tax rules regarding loans. Loans from MECs are subject to “last-in, first-out” (LIFO) taxation, meaning withdrawals or loans are considered to come first from earnings, which are then taxable. If the policyholder is under age 59½, loans from MECs may incur a 10% penalty on the taxable portion. Interest paid on policy loans is not tax-deductible for individuals, as these loans are considered personal loans.