There are many different types of permanent life insurance policies that offer a cash value, savings, or investment component. These plans may include whole life, universal life, and variable life insurance. In these insurance policies, the cash or investments are able to grow over time, allowing the policy holder another way to potentially build a significant amount of funds for current or future financial needs.
In many cases, even the guaranteed interest rate that is associated with a basic whole life insurance plan is generally more than that of a bank savings account. When this is the case, the funds within the life insurance policy will typically grow much faster – and on a tax deferred basis – providing a nice source of available funds for use should the policy holder need the cash.
How Life Insurance Policy Loans Work
In order to borrow funds from a life insurance policy, it is important to first determine how much cash is available in the policy. Typically, this information can be obtained by checking the policy statement. It is important to note that policies that are less than five years old will rarely carry a significant amount of underlying cash value.
Typically, the agent on the policy – or a company representative – can help to process the policy loan request. In most cases, a policy holder will receive the loan proceeds in the same manner that he or she pays their premiums. For example, if the policy holder pays premiums via check, then the proceeds will be sent to them by check.
It is also important that a plan for repaying the policy loan be devised before the funds are even obtained. Although insurance companies are not usually aggressive about repayment of such loans, leaving an unpaid balance could lead to negative consequences such as a lesser amount of death benefit, or even an unintentional policy lapse.
Important Life Insurance Policy Loan Considerations
In addition to a plan for repaying the loan, there are several factors that a policy holder should consider prior to borrowing cash from his or her plan. These include:
- Taxes – When a life insurance policy holder borrows against the cash value in their policy, it is not considered to be an actual distribution. This is because the amount that is borrowed should be paid back – with interest. Therefore, when such funds are borrowed, there will be no tax due on the portion of the funds that is considered to be gain. If, however, the cash value loan is not repaid, leading to a lapse of the policy, or if the policy is cancelled prior to loan repayment, then the policy holder will likely have some tax liability. Likewise, if the policy were to lapse due to borrowing too much from the policy, then the loan may be treated as being “forgiven” by the IRS. In this case, the funds will no longer be considered a loan but rather as ordinary income – and will thus be subject to ordinary income taxes.
- Death Benefit – Should a policy holder borrow funds from their policy, and then subsequently pass away prior to repayment of the funds, then the amount of the unpaid loan balance will be deducted from the amount of death benefit proceeds that are to be received by the policy’s beneficiary. In this case, a lesser amount of death benefit could put survivors into a negative financial situation, depending upon how much they need for final expenses and other pressing debts.
- Other Consideration – In addition, many insurance companies will require fees and/or administrative costs to the borrower when taking out a loan on their policy. It is important that the amount of these additional costs be factored into the overall equation.
Why Consider Borrowing from a Life Insurance Policy
While it is important to consider both the tax implication and death benefit considerations when borrowing funds from a life insurance policy, there are many viable reasons why a policy holder would want to do so.
First, these funds can provide a good way to pay off debt, without the need to use money from savings, investments, or other similar accounts. In some situations, the funds that are in a life insurance policy’s cash value may be the only source available to cover emergencies or other pressing expenses. This can potentially save an individual a great deal in interest charges and other fees if they would otherwise need to use credit for such instances.