Understanding Life Insurance Policy Loans

There are many different types of permanent life insurance policies that offer a cash value component – and because of this, one way for these policyholders to access cash quickly can be to borrow funds from the cash value.

In some cases, the policyholder can borrow policy loans on life insurance up to 90 percent of the total amount of cash that is in the policy.

But, while this can provide you with an easily accessible and inexpensive way to obtain funds quickly, it could have an effect on the amount of money that the beneficiary receives at a time they need it the most. So, it is important to be careful when borrowing from a cash value life insurance policy. Taking loans against life insurance policy can lapse a policy too, if not done in the proper manner.  Your agent can help with this decision.

There are other potential items to consider as well.  Like, are life insurance policy loans taxable? And the life insurance policy loan interest rates a company will charge.

Considerations When Borrowing From Your Life Insurance Policy.

When borrowing policy loans on life insurance or funds from a cash value life insurance policy, the loan is not considered to be a distribution. It is also not considered to be income to the individual. This is because the amount that is borrowed will eventually be required to be paid back.

On top of the payback amount, the borrower will also be required to pay at least a small amount of interest on the amount that is borrowed. Therefore, taxes are typically not due to life insurance policy loans.

If, however, the failure of the policyholder to repay the loan amount leads to either the lapse or cancellation of the policy, then there will be some tax implications. In this case, since the cash value of the policy would technically be used to repay the loan, then the amount that is paid will then be considered as income to the policyholder. In addition, any additional funds that are distributed upon the surrender of the life insurance policy would also be considered as income.

Taking Loans Against a Life Insurance Policy.

Also, if a life insurance policy were to lapse because the policyholder stopped paying premiums or they borrowed too much from the policy, the loan from the policy could be treated as being forgiven by the IRS.

A forgiven life insurance policy loan means that the loan is actually no longer considered to be a loan and is not required to be paid back. Thus, forgiven policy loans will be treated as ordinary income and are then subject to taxes.

Therefore, when a policyholder lapses their life insurance policy due to policy loans, they will also increase their gross income. This is due to the fact that the loans are then considered to be forgiven. Any loan that is in excess of the total amount of premiums that were paid into the policy is considered as part of the policy holder’s gross income after the policy lapses.

When an individual increases their gross income, then they technically are also increasing their tax liability. Because life insurance is taxed as ordinary income, then the policy holder’s overall tax rate may also increase on their regular income.

Why Borrow From Your Life Insurance Cash Value?

Aside from the tax considerations and the potentially lower amount of death benefit, there could actually be some viable reasons to consider borrowing from your life insurance policy’s cash value.

For instance, the funds that are borrowed from these plans are typically otherwise considered to be tax-free. Also, unlike borrowing money from certain types of qualified retirement accounts like your IRA or 401(k) plan, there aren’t usually any penalties for early withdrawals.

Given that, you can generally borrow money from your life insurance policy – even if you haven’t yet reached that magic age of 59 1/2 – without having to worry about being hit with a 10% IRS early withdrawal penalty.

Still Confused About Policy Loans on Life Insurance?

Need more details as to whether or not it makes sense to borrow from your cash value life insurance policy? Give us a call. We can help walk you through various scenarios – and assist you in other areas, too, as it pertains to coverage situations.