Borrowing From Life Insurance: Taxable Or Not?

Borrowing from your life insurance policy can be a quick and easy way to get your hands on some cash, but it's important to understand the tax implications. In general, the money you borrow from your life insurance is not considered taxable income, as long as the policy remains in force. However, if you surrender your policy or it lapses, and the amount you owe exceeds what you've paid in, you may have to pay income tax on any earnings from the investment. It's also important to note that the interest on the loan is not tax-deductible and must be paid annually. Failing to repay the loan and interest can result in a reduced death benefit for your beneficiary. Understanding the tax consequences of borrowing from your life insurance policy can help you make informed financial decisions and avoid unexpected tax bills.

Borrowing from a life insurance policy is generally tax-free

However, it's important to note that while the loan itself is not taxable, any interest charged by the insurance company will be. This interest is not deductible, and if it is not paid, it will be added to the loan amount. Additionally, if the loan is not repaid before the death of the insured, the insurance company will reduce the death benefit paid to the beneficiary by the amount of the outstanding loan.

It's also important to consider the potential tax implications if the policy is surrendered or lapses. If the policy is surrendered, any gains on the policy may be taxable as ordinary income. In the case of a lapse, if the loan balance exceeds what has been paid into the policy, this excess may be treated as taxable income by the IRS. Therefore, it's crucial to monitor the loan balance and ensure the policy remains in force to avoid unexpected tax liabilities.

Overall, while borrowing from a life insurance policy can provide a tax-free source of funds, it's important to understand the potential risks and tax consequences associated with such loans. Proper planning and consultation with a financial advisor can help individuals make informed decisions and avoid unwanted tax surprises.

Surrendering your policy could result in a tax bill

Surrendering your life insurance policy means giving up your coverage in exchange for a payout. This can be a quick way to get cash, but it's important to understand the potential tax implications before making a decision.

When you surrender your policy, the amount you receive is called the cash surrender value (CSV). This is the total value of your policy minus any fees or surrender charges. If the CSV exceeds the amount of premiums you've paid into the policy (your cost basis), the excess amount is typically taxed as ordinary income. This means you'll have to pay income tax on the difference.

For example, let's say you've paid $30,000 in premiums over the years and your policy has a CSV of $45,000. If you surrender the policy, the additional $15,000 would be considered taxable income, and you'll need to include it when filing your taxes. This could potentially push you into a higher tax bracket for that year.

It's important to note that the tax consequences of surrendering your policy are separate from any outstanding loans you may have against the policy. If you have a loan, it will be repaid from the CSV, but the tax implications remain the same. The loan itself is not taxable, but the gains on your policy are.

To calculate the potential tax bill, you need to compare the CSV (before any fees or loan repayments) with your cost basis. The difference between these two amounts represents the taxable gain. This gain will be taxed as ordinary income, and you'll need to report it on your tax return.

It's always a good idea to consult with a financial advisor or tax professional before making any decisions about your life insurance policy. They can help you understand the specific tax implications for your situation and advise you on the best course of action to minimize any potential tax liabilities.

Death benefits are usually tax-free

If the beneficiary receives the death benefit in installments that include interest, the interest will be taxable. The death benefit is typically not taxed as income, but any interest that accumulates on those payments will be taxed as regular income. This is because the interest is considered taxable income, even though the original death benefit is not.

Another exception occurs when a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary. If the estate's total value is large enough, it may trigger estate taxes, reducing what the loved ones ultimately receive. If the death benefit goes to your estate, it may be subject to federal or state estate tax if the estate exceeds the estate tax exemption amount.

In the case of an employer-paid group life plan, if the plan pays out more than $50,000, it may be taxable according to the Internal Revenue Service (IRS). Otherwise, the death benefit is typically paid to beneficiaries tax-free.

Additionally, if the life insurance proceeds are included as part of the deceased's estate and, together with other assets, exceed the federal estate tax threshold, estate taxes must be paid on the proceeds over the allowed limit. As of 2023, the federal estate tax threshold was $12.92 million.

To summarise, while death benefits are usually tax-free, certain situations can trigger taxes, such as receiving the benefit in installments with interest or the estate exceeding the tax exemption limit.

Interest on loans is not tax-deductible

Borrowing from your life insurance policy can be a great financial option in the case of a sudden financial emergency or debt that needs to be paid. The loan is generally not taxable as long as it doesn't exceed the sum of the insurance premiums you have paid and the policy remains in effect. However, interest on loans is not tax-deductible.

Interest Charges

Life insurance companies typically charge interest on policy loans. This interest is added to the loan balance, and if left unpaid, can lead to the policy lapsing. It is important to note that the interest charged on life insurance loans is not tax-deductible. This means that you cannot claim this interest as a deduction on your tax returns.

Repayment Options

While repaying the loan is not mandatory, it is in your best interest to do so to avoid negative consequences. You have several options for repayment, including making periodic payments of principal and annual interest, paying only the annual interest, or deducting the interest from the cash value of your policy. It is recommended to make at least the minimum interest payments to prevent the loan from growing.

Impact on Death Benefit

If the loan is not repaid before the insured person's death, the insurance company will reduce the death benefit by the amount that is still owed. This means that the beneficiaries will receive a lower payout. Therefore, it is essential to keep track of your loan balance and ensure that your policy remains active by making the necessary payments.

Tax Implications

While the loan amount itself is generally not taxable, any interest charges that are left unpaid can lead to tax implications. If the policy lapses due to non-payment of premiums or insufficient cash value, any outstanding loan balance that exceeds what you have paid into the policy will be treated as taxable income. This means you will owe income tax on the difference between the loan balance and your cost basis (total amount of premiums paid).

Alternative Options

If you are considering borrowing from your life insurance policy, it is important to weigh the benefits against the potential risks and costs. Interest charges and the impact on the death benefit may make this option less favourable than other alternatives. It may be worth exploring other options such as personal loans, credit cards, or borrowing from friends or family, as these may offer more favourable interest rates and repayment terms. Additionally, consulting with a financial advisor can help you make an informed decision that aligns with your financial goals.

Loans can be taken from permanent life insurance policies

Borrowing from a permanent life insurance policy can be a convenient way to access funds when faced with unexpected expenses or financial emergencies. This type of policy, which includes whole life, adjustable life, universal life, and indexed universal life insurance, allows you to build up a cash value over time that can be borrowed against. Here's what you need to know about taking loans from permanent life insurance policies:

Eligibility and Requirements

To be eligible for a loan from your permanent life insurance policy, you must have accumulated sufficient cash value. The minimum amount required varies by insurer, and it usually takes a few years for the policy to build up enough value. Once your policy has reached the required minimum, you can borrow against the cash value without any credit checks or approval processes.

Tax Implications

Borrowing from your permanent life insurance policy is generally tax-free. The funds you receive are not considered taxable income as long as the policy remains in force. However, if you surrender your policy or if it lapses with an outstanding loan, you may owe taxes on any earnings from the investment. It's important to consult a financial advisor to understand the tax implications before borrowing.

Interest and Repayment

Life insurance loans typically come with interest rates ranging from 5% to 8%, which is lower than the average rate for personal loans or credit cards. While repayment is often optional, it is in your best interest to repay the loan as soon as possible to minimize the interest owed. If the loan is not repaid before the insured person's death, the insurance company will reduce the death benefit by the amount of the loan and accumulated interest.

Advantages

Borrowing from a permanent life insurance policy offers several advantages. It provides quick access to funds without the need for credit checks or a lengthy approval process. You also have the flexibility to use the money for any purpose without the restrictions typically associated with traditional loans. Additionally, there is no strict repayment schedule, although regular payments are recommended to manage the interest.

Disadvantages

There are also some disadvantages to consider. If the loan and interest are not repaid, the death benefit will be reduced, potentially impacting the financial security of your loved ones. Additionally, if the loan amount and interest exceed the policy's cash value, the policy may lapse, resulting in a loss of coverage and potential tax implications.

Frequently asked questions