Life insurance policy loans: how they work and what the risks are

What a policy loan is

It is money the insurance company lends you using your policy’s cash value as collateral. You are not taking the money out of the policy: the cash value stays there and the insurance company uses it to back the loan. That is why it is a right under the contract, not a loan you apply for at a bank.

It only exists in permanent policies with cash value. Term life insurance generally has no cash value, so it does not allow loans.

How it works, step by step

The process is usually simple:

• You check how much you can borrow: the insurance company tells you the available amount, which is usually a portion of the cash value.
• You request it: with a form or through the insurance company’s portal.
• Interest is charged: the rate is set in your policy contract.
• You decide how to repay it: you can pay the loan and interest whenever you want, or let the interest be added to the debt.
• If you do not repay it: when you pass away, the insurance company deducts what you owe, with interest, from your family’s benefit.

What people forget most: if you do not pay the interest, it is added to the loan and the debt grows every year.

The risks of a policy loan

The Florida Department of Financial Services guide warns that loans, together with changes in rates and costs, can take away the policy’s ability to pay for itself and force you to start paying premiums again. These are the main risks:

• Less protection for your family: the outstanding loan and its interest are subtracted from the death benefit.
• The policy can lapse: if the debt grows larger than the cash value, the insurance company generally notifies you and, if you do not pay, the policy ends.
• Taxes when it lapses: if the policy ends with a loan outstanding, the debt that is canceled can count as taxable income for the part that exceeds your cost in the policy (generally, premiums paid minus dividends and other amounts you received tax-free), even if you receive no cash. The Tax Court applied it that way in Sanders v. Commissioner (2010).
• In universal life and IUL, less value to cover charges: the borrowed money may earn a different interest rate under the contract and leave less value to pay the cost of insurance, which rises with age, as the Wisconsin Office of the Commissioner of Insurance warned.

Policy loans and taxes

Under section 72(e) of the Internal Revenue Code, in a policy that is not a MEC a loan is not treated as a withdrawal, so it is generally not taxable while the policy stays in force. A withdrawal (not a loan) is generally taxable only on the part that exceeds what you paid in premiums.

If the policy is a MEC (modified endowment contract), everything changes: loans do count as distributions, the taxable gain comes out first and, before age 59½, an additional 10% applies (section 72(v)). A policy becomes a MEC when it receives more money than the 7-pay test in section 7702A allows, and a material change to the policy can restart that test.

If you cancel the policy, according to IRS Publication 525 you report as income what you receive above your cost, and unpaid loans count in that calculation.

Tax rules depend on each policy and each person. Before taking a large loan, or canceling a policy with a loan, talk to your accountant.

Policy loan vs. bank loan vs. withdrawal

The differences that matter most:

• Policy loan: a right under your contract, no set repayment date and the cash value stays in the policy; if you do not repay it, the benefit goes down.
• Bank loan or credit card: they check your credit, you have fixed payments and the rate depends on your history; it does not touch your insurance.
• Withdrawal from the policy: it is not repaid and does not charge interest, but it permanently lowers the cash value and, generally, the benefit; it may be taxable on the gain.

How to use a policy loan without putting your family at risk

Good practices we recommend:

• Borrow only what you need and have a plan to pay it back.
• Pay at least the interest every year so the debt does not grow.
• Review the policy’s annual statement: how much you owe, how much value is left and whether there is a risk of lapse.
• Ask the insurance company for an updated illustration before a large loan.
• If you no longer want the policy, do not let it lapse with a loan on it without first talking to your consultant and your accountant.

Frequently asked questions