In times of uncertainty, Americans turn their attention to their liquidity—what cash they have on-hand and what cash can they quickly access if needed. Cash out securities? Raid the qualified plan? Get a bank loan against a home or a business? Sell a kidney? All of these have serious detractors, including loss of capital, in-efficient taxation, penalties, adverse lending rates and, in the case of selling that kidney, possible criminal implications. Taking a loan from your life insurance policy may be the solution to satisfy an emergency need for money.
Life insurance has many positive characteristics and the most important one policyowners often fail to remember is that life insurance is an asset. In fact, permanent policies such as whole life and universal life contracts have accumulated cash value which never declines, a characteristic absent in most other things we own. When there is volatility in the market, we often check our retirement accounts, investments accounts and Zillow to watch as our other assets move up-and-down. We don’t have that worry with properly serviced, permanent life insurance.
Remember, the “Holy Trinity” of life insurance is:
The income tax-free death benefit;
Tax-free growth of premium payments in the form of a policy’s cash value; and,
The ability to take tax-free or tax-advantaged loans.
It is easy to borrow to against the cash value of a life insurance policy. There aren’t any financial qualifications to fulfill or applications to complete. The policy owner simply fills out the insurance company’s loan form, submits it and, in a matter of hours or days, receives a wire or check for the amount requested.
While the process of obtaining a loan is quick and painless, there are a number of things a policyowner should consider before making the loan request.
Amount
The maximum loan amount most policies will permit is up to 90% of the surrender cash value. Anything more than that amount puts the policy very close to being surrendered, and a surrender may have negative tax consequences.
Loan Rates
Most life insurance companies do not look at policy loan interest to be a profit center and, therefore, rates are usually quite reasonable. Current loan rates vary by insurer and the policy but typically fall between 3% and 8%. In addition, the cash value in the policy continues to earn interest during the loan so there is often a spread of the loan interest rate. For example, if your cash value was guaranteed to grow at a rate that was within 2% of your loan interest rate of 6%, it would be guaranteed to be at least 4%. Remember, a policyowner is borrowing against the policy and not from the policy so the policy will continue to earn interest from the insurance company.
Terms
There is not a pre-determined repayment schedule with a life insurance policy loan. If payments are not made or do not cover the loan interest costs, the interest will continue to accrue, and the loan balance will not decrease. As long as the outstanding loan plus the accumulated interest does not exceed the policy’s surrender cash value, the insurance company will not force a surrender of the policy to recoup the loan balance and interest. If there is a loan against the policy at the time of death of the insured, the death benefit will be reduced by the amount of the loan.
Taxation
If the life insurance policy is a non-MEC (“Modified Endowment Contract”) policy, loans are tax-free as long as the policy remains in-force. If the policy is surrendered or lapses, the policyowner will face taxation at ordinary income tax rates on the amount of cash value growth above the total premiums paid.
If the policy loan balance and accumulated interest grows too large, the policy will lapse, and the life insurance company will force a surrender of the policy. The insurance company will use the cash proceeds from the surrender to pay off the loan balance. When this occurs, there isn’t any additional money from the policy to use to pay the federal income tax bill and the policyowner will be on the hook for the taxes due at ordinary rates on the cash value growth within the policy.
If the life insurance policy is a MEC, loans are treated as distributions and distributions are first treated as gains, subject to ordinary income taxation and possibly subject to an additional 10% penalty tax if the owner is under age 59 ½. Distributions also include capitalized loan interest. This means a policyowner may owe taxes when taking a loan from a MEC.
No Strings Attached
Policy loans are not restricted by the life insurance company and the policyowner is free to spend the proceeds as they see fit. Insurance companies cannot stipulate that the money goes toward a specific purchase. Additionally, taking a loan and repaying it…or not…doesn’t impact a credit score and lenders cannot see a policy loan when pulling a credit report.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.