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How do life insurance policy loans work?

How do life insurance policy loans work?

If you have a permanent life insurance policy that builds cash value, you likely have the ability to borrow money from the policy.

Cash value life insurance builds an account value that policyholders can access. There are two basic types of cash value life insurance: whole and universal.

Whole life insurance is meant to be owned for a person’s “whole life” and the policyholder pays the same level premium for as long as he or she owns the policy. It builds cash value from the reserves that insurers set aside to ensure they can pay a death benefit.

Universal life (UL) insurance is more flexible than whole life, but also has less of a guarantee. When you buy a universal life insurance policy, your premiums support the amount of coverage you elect to own, which is called the face amount. Each premium payment you make goes into the policy’s account value. From this account, the insurance company deducts its costs and expenses. The amount left over collects interest, which then becomes the cash value of your policy. You can vary the amount, timing, and frequency of payments as long as the policy has enough cash value to cover expenses.

Advantages of borrowing against life insurance
Depending on the company that issued your policy, you may be able to borrow up to 90 percent of the policy’s cash value at any time. When you withdraw money from a life insurance policy, it’s considered a policy loan, even if you don’t intend to repay it. And because it’s a loan, the withdrawal is not considered taxable income. For tax purposes, borrowing money from a life insurance policy is no different than a student loan, a home equity loan or a car loan. Since the intention is to repay the money with interest, the IRS does not consider a life insurance policy loan as income.

One of the main advantages of borrowing against a life insurance policy instead of through traditional means is that you don’t have to qualify for a policy loan. There are no credit checks to pass and no collateral to securitize the loan.

Another advantage is that, depending on the provisions of your contract, you can often take as long as you wish to pay back the policy loan. You can even choose not to repay the loan and accept a lower death benefit.

Many people, in fact, buy life insurance policies in their 40s and 50s so that it builds up enough cash value that they can use to supplement their retirement income. Basically, each withdrawal from the policy for retirement income is a policy loan, which means it’s tax-free income. Those loans are generally not repaid, and whatever is left in the policy after the owner(s) passes away is the death benefit received by the beneficiaries.

Other people use their life insurance policies for large, one-time expenses like helping pay for a child’s college education, making a downpayment for a home or vacation property, or paying off medical bills.

If you choose to repay a policy loan, you will often receive a more favorable interest rate than you would through traditional lenders, and the loaned funds will continue to earn interest as if they were never withdrawn.

Also, because life insurance withdrawals are not taxable, they don’t impact the formula the IRS uses to determine whether to tax your Social Security benefits.

Something to keep in mind is that a policy loan is not a withdrawal from an account that you own. You’re basically borrowing money from the life insurance company and using your policy as collateral.

The downsides of borrowing from life insurance
If you pass away with an outstanding policy loan, your beneficiaries will receive a lower death benefit than they would have had you not withdrawn any funds from the policy. Therefore, the reduction in the tax-free death benefit is the “tax” you pay on policy loans you do not repay.

In addition to lowering the policy’s death benefit, another potential downside to a life insurance policy loan is the possibility of borrowing too much out of the policy.

The cash value component of a whole life or universal life policy is what supports the policy; it’s how the various fees, mortality charges and the cost of insurance are paid. If you withdraw too much of the cash value, there won’t be enough to pay those fees, and you could lose all of the life insurance coverage.

If that happens, it could also trigger a taxable event, because you will have essentially collected tax-free income and will not be paying it back because there is no longer a policy to repay it to.