Borrowing From Kids: Life Insurance Inheritance

Life insurance is a way to provide financial security for your loved ones after your death. It can also be used to leave an inheritance for your children, which can be especially useful if you want to avoid probate or have the funds distributed according to specific guidelines. In some cases, you may be able to borrow money against the value of your life insurance policy, but this is not always possible and depends on the type of policy you have.

There are two main types of life insurance: term life and permanent life. Term life insurance lasts for a set number of years and does not build up a cash value, so you cannot borrow against it. Permanent life insurance, on the other hand, can last your entire life and often includes a cash value component that you can borrow against. This type of policy is generally more expensive than term life insurance, but it offers the potential for borrowing money against the policy's value.

If you have a permanent life insurance policy with a cash value, you may be able to borrow against it by taking out a loan from the life insurance company. The loan is typically based on a percentage of the policy's cash value, and the specific rules will depend on the insurer. It's important to note that borrowing against your life insurance policy can have both advantages and disadvantages. While it can provide quick access to cash, it may also reduce the death benefit and increase the risk of the policy lapsing if the loan is not repaid.

Borrowing from a life insurance policy

Firstly, it's important to note that you can only borrow against a permanent life insurance policy, such as a whole life insurance or universal life insurance policy. These policies are more expensive than term life insurance but have no predetermined expiration date. While term life insurance is a cheaper and more suitable option for many, it does not have a cash value and is designed to last for a limited period, generally anywhere from one to 30 years. In some cases, a term life policy can be converted into a permanent policy, which allows cash value to build up.

If you have a permanent life insurance policy, you can borrow against it as soon as there is enough cash value built up to take a loan in the desired amount. This can take several years, depending on the structure of your policy. Each insurance company will have different rules in place, but generally, you can borrow up to 90% of the policy's cash value.

The process of borrowing from a life insurance policy is straightforward. You take out a loan against the value of the death benefit within the policy. The death benefit is the portion of money paid to the beneficiary when the policy owner passes away. The value of the policy itself is used to guarantee that the loan will be paid back. These loans are taken out with the life insurance company and often have a simpler approval process, as you technically own the death benefit and cash value of your policy. Life insurance companies will charge interest on the loan, which can be paid monthly or allowed to accrue and paid later.

However, there are some disadvantages to consider as well. If you are unable to make timely loan payments, you may lose your life insurance policy. If the loan is not paid back before the policy owner passes away, the beneficiary will only receive a reduced death benefit. If the policy lapses, you may have to pay taxes on it since the tax structure will change.

In conclusion, borrowing from a life insurance policy can be a convenient way to access cash, but it's important to understand the potential risks and implications before making a decision.

Pros and cons of borrowing against life insurance

Borrowing against your life insurance policy can be a quick and easy way to get cash in hand when you need it. However, it is important to understand the pros and cons before making a decision. Here are some key points to consider:

Pros of Borrowing Against Life Insurance:

• No lengthy loan application process: There is no formal approval process, credit check, or income verification required as the value of the plan is technically yours.
• Flexible repayment schedule: You can pay back the loan at your leisure and there is no required monthly payment.
• No impact on credit score: Life insurance loans will not affect your credit score as they are not reported to credit bureaus.
• Tax advantages: In most cases, policy loans are not considered taxable income by the IRS. Additionally, the interest rates on policy loans are typically lower than those of bank loans.
• No collateral required: Your policy's cash value acts as collateral for the loan, so you don't need to put up any other assets.

Cons of Borrowing Against Life Insurance:

• Reduced death benefit: If the loan is not repaid before the policyholder's death, the loan amount plus interest will be deducted from the death benefit received by the beneficiaries.
• Risk of losing insurance coverage: If the loan balance exceeds the cash value of the policy, it could lapse and be terminated by the insurance company, resulting in a loss of insurance protection.
• Interest charges: Interest is charged on the outstanding loan balance, and if left unpaid, it will accrue and increase the total amount owed.
• Possible tax consequences: Borrowing more than the amount invested in the policy may trigger tax implications if the policy is surrendered or cancelled.
• Impact on policy benefits: Borrowing against the cash value of the policy may deplete the funds available for premium payments, potentially affecting the policy benefits.

Tax implications of life insurance inheritance

Life insurance policies can be used to pass money to heirs tax-free. However, there are some instances where beneficiaries may have to pay tax on the proceeds.

The life insurance death benefit, or payout, is generally not considered taxable income, and beneficiaries are usually not required to pay income tax on the proceeds. This means that the proceeds are tax-free for the beneficiary, providing financial support to loved ones after the policyholder's death.

However, there are a few exceptions to this. Firstly, if the beneficiary receives interest on the payout, they will have to pay tax on this interest. This typically occurs when the beneficiary receives the payout in installments, and the principal amount generates interest while being held by the insurer. Secondly, if the payout is made to the insured's estate, rather than directly to a named beneficiary, it could be subject to estate taxes. This is only the case if the estate exceeds a certain value; in 2024, estates over $13.61 million are subject to estate tax. Finally, if the owner of the policy is not the same person as the insured, the payout to the beneficiary could be considered a taxable gift.

To avoid paying taxes on a life insurancesection 2042 of the Internal Revenue Code states that the insured must transfer ownership of the policy to another person or entity. This can be done by setting up an irrevocable life insurance trust (ILIT), which removes the policy from the insured's estate. However, this type of trust cannot be revoked after it is set up. Another option is to be mindful of gift tax limits and ensure the policy's cash value does not exceed these limits. For 2024, the annual gift tax exemption is $18,000, and the lifetime exclusion amount is $13.61 million.

Distribution options for life insurance proceeds

Life insurance proceeds are typically paid out as a lump sum, but beneficiaries can also choose to receive them in instalments or as an annuity. Here are some options for how to distribute life insurance proceeds:

Pay off debt

If you're burdened by high-interest credit card balances or student loans, you may want to consider using the life insurance payout to rid yourself of these debts. This will free up disposable income that can be redirected towards retirement or savings accounts.

Create an emergency fund

A life insurance benefit can be used to start or add to an emergency fund. Financial professionals recommend that working Americans have at least three to six months' worth of living expenses set aside in an emergency fund, even more for those who are self-employed or lack income stability.

Purchase an annuity

For those who need the life insurance proceeds to cover monthly living expenses, such as young families or retirees, purchasing an annuity may be a good option. Annuities provide a guaranteed income stream, either immediately or in the future, and can help accomplish different goals. However, it's important to carefully read the marketing material and consult a financial professional before making a decision.

Collect installments

Installment payments can provide a similar income guarantee to beneficiaries as annuities. The life insurance company might pay out a certain percentage of the total death benefit annually over a number of years, with the remaining benefit earning interest for the beneficiary. However, while the death benefit itself is not taxable, any interest earned on instalment payouts may be subject to tax.

Invest for growth

If you don't need the life insurance benefit immediately, you could invest the lump-sum payout in a mix of stocks and bonds for potential growth. A financial professional can help determine the appropriate investment mix based on your age, goals, and risk tolerance. Life insurance proceeds can also be used to supplement retirement savings or to invest in a vacation home.

Children's education

Beneficiaries could put a portion of the life insurance payout into a college fund for their children, such as a 529 college savings plan or a Uniform Gift to Minors Act (UTMA) account. Contributions to a 529 plan are made on an after-tax basis, but earnings and distributions are tax-free if used for qualified education expenses.

A combination approach

For larger death benefits, a combination of approaches may be appropriate. For example, a beneficiary could use part of the benefit to create a guaranteed income stream through an annuity or instalment plan, while investing the rest in the stock market for potential upside. This strategy provides short-term income coverage while also generating potential returns over the longer term.

Establishing a legacy

For those who have already saved enough to provide for their financial needs, life insurance proceeds can be used to support a favourite charity or organisation. This can be done through direct donations or by purchasing a new life insurance policy and designating the charity as the beneficiary after your death.

How to borrow against a life insurance policy

Borrowing against a life insurance policy can be a quick and easy way to get cash. However, it is important to note that you can only borrow against a permanent life insurance policy, such as a whole life insurance or universal life insurance policy. These policies are more expensive than term life insurance but have no predetermined expiration date. They also have a cash value component, which is a savings-like account that grows tax-free over time. This is what you can borrow against.

When borrowing against your life insurance policy, you are taking out a loan from the life insurance company, with the value of the policy itself used as collateral. There is usually no approval process, credit check, or formal requirements, as the value of the plan is technically yours. The loan is also not recognised by the IRS as income, so it remains tax-free as long as the policy stays active. However, it is expected that the loan will be paid back with interest, and there is a risk of the policy lapsing if the loan is not paid back.

Each insurance company will have different rules in place, but generally, you can borrow up to 90% of the policy's cash value.

Pros and cons

Borrowing against your life insurance policy can be beneficial if you need cash quickly, don't want to use other assets as collateral, or want a flexible repayment schedule. However, there are also some disadvantages. If you are unable to make monthly loan payments, you may lose your life insurance plan, and if the loan is not paid back before the policy owner passes, the beneficiary will only receive a portion of the death benefit. There is also a risk of the policy lapsing, which could result in having to pay taxes on the loan.

You can borrow from a life insurance policy as soon as there is enough cash value built up to take out a loan. This can take several years, depending on the structure of the policy.

Frequently asked questions