Life Insurance Loans: Are They Taxable?

Borrowing from your life insurance policy can be a good option in case of a financial emergency, but it's important to understand the tax implications. Generally, the loan itself is not taxable as long as it doesn't exceed the sum of the premiums you've paid. However, if you don't pay back the loan and your policy lapses, you may have to pay income tax on any earnings from the investment. It's also important to note that interest on the loan is not tax-deductible and must be paid annually to avoid being added to the loan amount.

Borrowing from your life insurance policy

Types of life insurance policies

Firstly, you can only borrow against a permanent life insurance policy, meaning either a whole life insurance or universal life insurance policy. Term life insurance, a cheaper and more suitable option for many people, does not have a cash value. It is designed to last for a limited period and thus does not qualify for borrowing against. However, in some instances, a term life policy can be converted to a permanent policy, which would open the door to borrowing money in the future.

Borrowing specifics

When borrowing from your life insurance policy, you are essentially borrowing the premiums you and your spouse have paid in. For example, if you've paid $15,000 in premiums, you can take one or several loans totalling $15,000, tax-free. The amount of your policy is the collateral for the loan.

Repayments

You do have to pay back the loan, and interest on the loan accrues annually. The interest must be paid annually, and if not, it's added to the loan amount. Failing to repay your loan and interest means that the loan may become taxable income. Also, if you or your spouse die with an outstanding loan or interest balance, the balance is deducted from your policy's amount, meaning there will be less money for your beneficiary.

Tax implications

The loan is not recognised by the IRS as income, and therefore it remains tax-free as long as the policy stays active. However, if you surrender your policy or your policy lapses, you must pay taxes on the money that came from interest or investment gains, even if you have an outstanding loan.

Surrendering your life insurance policy

Surrendering a life insurance policy involves cancelling your coverage in exchange for a lump sum value. This sum is known as the cash surrender value and is generally less than the cash value amount of the policy. The surrender value includes any surrender fees for the policy, which are taken from the cash value balance when you cancel the policy. Surrender value also consists of the amount of any outstanding loan balances on the policy.

There are several reasons why you might want to surrender your life insurance policy:

• Cost: If you can no longer afford your premiums, you could surrender your policy and use the surrender value in cash instead of making monthly premium payments.
• Cash needs: Surrendering a life insurance policy will give you access to a lump sum of cash. However, there may be ways to access your cash value without giving up coverage, such as a policy loan.
• Better coverage: You may find better coverage from a new policy and want to surrender your existing one.
• Better price: You might find a life insurance policy with a better price.
• No longer needed: Life insurance coverage may no longer be necessary if no one relies on you financially.

When you surrender your life insurance policy, you are making a decision to use the policy's cash value. A cash value life insurance policy lets you build savings in a special cash value savings account tied to the policy. As you pay your premiums, part of your payment goes into the cash value account. That cash account grows each year.

You can access your funds in several ways, one of which is through a policy surrender: cancelling the policy in exchange for a lump sum of the policy's surrender value. Surrendering a policy means you're dropping coverage, and your beneficiaries will no longer receive a death benefit. You may also face tax liabilities.

In general, you'll only pay income tax on interest or earnings over the amount you paid into the policy. The tax-free portion typically includes any money you paid in premiums over the life of the policy. For example, if you paid $50,000 into your policy's cash value via premiums and the surrender value is $60,000, you'll generally have to pay taxes on the $10,000 over what you paid into the policy.

When to surrender your life insurance policy

There are generally no restrictions on when you can surrender a life insurance policy – as long as you've made it through the surrender period. This period varies by policy and could be a couple of years to over 15 years. After the surrender period, the exact timing depends on your personal preference or financial situation. However, most policies require you to pay surrender fees when surrendering a policy. A surrender fee is a fee the life insurance company charges for you to cancel your insurance contract early. Surrender charges often decrease over the policy's life, with some disappearing entirely after a specific time. That means the longer you wait to surrender the policy, the less you'll likely pay in surrender fees.

How to surrender your policy

Most life insurance companies make it reasonably straightforward to surrender your policy. While you'll want to check your policy for details, most policies require you to contact your insurance company or your insurance agent. You may have to sign paperwork confirming your surrender. Once the process is in motion, you likely won't have to do much but wait for the surrender value check. The insurance company handles the details of calculating your final payout.

Alternatives to surrendering your life insurance policy

You don't have to surrender your life insurance policy to access your cash value. Some additional ways to use your cash value while maintaining your coverage include:

• Borrow from your cash value: You can borrow against your permanent life plan's cash value at low-interest rates and favourable terms. Policy loans have no due date. However, keep in mind that interest accumulates on your outstanding loan balance. Your policy can lapse if the loan balance grows larger than your remaining cash value.
• Withdraw from your cash value: Withdrawing from your cash value lets you tap into your wealth without a loan and without surrendering your policy. However, withdrawals may trigger tax consequences if you withdraw investment gains. Furthermore, withdrawals may reduce your death benefit.
• Use your cash value to pay premiums: Many permanent life insurance policies let you pay premiums with cash value once you accumulate enough. This can help you cut your life insurance costs while maintaining full coverage. However, if you drain your cash value, your policy can lapse.

Interest on life insurance loans

Accumulation of Interest

Life insurance loans are not interest-free. Interest accumulates annually on the borrowed amount, and if left unpaid, it is added to the loan balance. This interest is typically charged at a rate between 5% and 8%, although it can vary depending on the insurance company and market trends. It is essential to keep track of the interest to ensure it does not exceed the cash value of the policy, as this could lead to a lapse in coverage.

Impact on Death Benefit

If the loan and interest remain unpaid at the time of the policyholder's death, the insurance company will deduct the outstanding balance from the death benefit. As a result, the beneficiaries will receive a reduced payout. It is crucial to inform your beneficiaries about the loan and repayment plan to avoid any surprises.

Tax Implications

While the loan amount itself is generally not taxable, the interest accrued can have tax implications under certain circumstances. If the policy lapses or is surrendered before the loan and interest are fully repaid, the IRS may categorise the loan as taxable income. Additionally, if the loan and interest exceed the cash value of the policy, the excess amount may be treated as income by the IRS, resulting in tax liability.

Repayment Options

Policy loans do not usually have a fixed repayment schedule, but it is essential to make regular payments to avoid a policy lapse. Repayment options include periodic payments of principal and interest, paying only the interest, or deducting the interest from the cash value. Setting up automatic payments and creating a personal repayment schedule can help manage the loan effectively.

In summary, while life insurance loans offer quick access to funds with flexible repayment options, it is crucial to understand the implications of the accumulating interest. Regularly monitoring the loan balance and interest, as well as making timely payments, can help prevent negative consequences such as reduced death benefits or tax liabilities.

Death benefits

The death benefit is the amount of money your insurance company will pay out to your beneficiaries if you pass away during your policy’s term. While the death benefit is typically paid out in a lump sum, beneficiaries can choose other payment options. The amount they receive depends on the face value of your policy minus any withdrawals from your cash value account or policy loans you didn't repay.

In many cases, the money beneficiaries receive from a life insurance payout is not taxed as income. However, there are some exceptions.

If the policyholder names their estate as a life insurance beneficiary, taxes might apply. The taxes loved ones may pay depend on the estate’s value.

If the insured and the policy owner are different individuals, there may be taxes involved.

If a beneficiary chooses to delay the payout or take the payout in installments, interest may accrue. In that case, the interest paid to the beneficiary may be taxed.

However, if a life insurance policy with an outstanding loan on it is held until death, the insurance company will use the death benefit proceeds to repay the loan, with the remainder paid to the beneficiary. This is not necessarily problematic, as the death benefit is already tax-free.

Life insurance as an investment asset

Life insurance can be a good investment opportunity. It can offer a benefit to loved ones when you pass away, but it can also be a financial asset during your life. Some life insurance policies can become a financial asset for you to use during your lifetime, similar to an IRA or mutual fund.

There are two main types of permanent life insurance that can be used as an asset: whole life insurance and universal life insurance. Whole life insurance is the most common type of permanent life insurance, which, in addition to a death benefit, offers the policyholder the ability to accumulate cash value. This works because a portion of the premium you pay every month is put into a cash value account. Your cash value will accumulate over time at a minimum guaranteed rate indicated by your policy.

Universal life insurance functions similarly to whole life insurance, allowing policyholders to grow an asset by accruing interest over time that can be borrowed against. However, with universal life policies, the premiums aren't set and are subject to change, and there are no guarantees on the rate your money will earn over time.

When investing in a life insurance policy, it's essential to consider the type of policy that best suits your needs. Not every policy features a cash value component; only policies that do can be used as investment tools because they allow policyholders to borrow against accumulated funds.

• Take a loan from your policy: You can borrow against the cash value of your permanent life insurance policy. Just be sure to read the fine print if you go this route, as the interest rate can be fixed or variable and is set by the insurer. Also, if you take a loan against your policy and it's not paid off at the time of your death, any outstanding balance that you owe will be subtracted from what your beneficiaries inherit.
• Use your policy as collateral for a loan: In some situations, you can use your life insurance policy as collateral for a loan, which can make it easier for you to get approved or get a better rate on the loan. However, keep in mind that if you die before paying it back, whatever you still owe will come off the top before your beneficiaries see their benefit.
• Withdraw funds: Rather than taking a loan that must be paid back, you can also simply make withdrawals from your policy that are yours to keep. Just note that if your withdrawal dips into your investment gains, you'll need to pay taxes.
• Option for "accelerated" benefits: Some policies enable you to receive your benefits during your lifetime if an unexpected or extreme medical emergency arises, such as cancer, a heart attack, or kidney failure. Most policies with this option allow you to withdraw anywhere from 25% to 100% of your policy's value.
• Surrender the policy (cash out): Surrendering your policy simply means cancelling your coverage. When you do this, you get back the cash value you put in, less any fees your insurance company may charge. Just study the fine print carefully, as in some cases, those fees may be quite high.

Life insurance can be a good investment tool, but it's important to use it effectively. Permanent life insurance can provide portfolio diversification, risk management benefits, and help you achieve long-term financial goals. Here are some of the benefits of using life insurance as an investment:

• Tax advantages: The cash value in your policy grows tax-deferred, meaning you won't pay taxes on any earnings until you withdraw them. If structured correctly, death benefits are generally income-tax-free to beneficiaries.
• Asset protection: In many states, permanent life insurance policies are protected from creditors, making them a valuable tool for asset protection strategies, especially for business owners or professionals facing liability issues.
• Potential income streams: A well-managed life insurance policy can be an income stream during retirement through policy loans and withdrawals. It's like having a mini pension plan within your reach.

However, there are also some considerations and drawbacks to keep in mind when using life insurance as an investment:

• Fees and charges: Surrender charges, administrative costs, and premiums can affect your overall return on investment.
• Potential conflicts with other investment strategies: Investing heavily in a life insurance policy might limit your ability to invest in other areas due to liquidity constraints.
• Comparatively low returns: Life insurance investments have conservative growth rates compared to traditional investments like equities or bonds.
• Limited flexibility: Some types of permanent life insurance have limited flexibility when adjusting premium payments or death benefits, making them less attractive to certain investors.

In conclusion, life insurance can be a valuable investment asset, providing financial protection and growth opportunities. However, it's important to consider the potential benefits and drawbacks and consult with a financial professional before making any decisions.

Frequently asked questions