Cash value loans and their tax traps

In short

A friend of mine once told me his life insurance policy was "like a bank account with a death benefit on top." I understood why he felt that way. A permanent policy does build a cash value, and the insurer will often lend against it. But borrowing from your own policy is not free money, and the tax rules can bite hard. If you are holding a whole life or universal life policy, find out how much you owe on it and how much you paid in. Ask the insurer in writing what would happen if the policy ended today. Learn the difference between your basis, which is what you paid in, and your gain, which is what the policy earned. Keep the policy in force, because a lapse with a loan outstanding can create a tax bill with no cash to pay it. Talk with a tax professional before you borrow a large sum. Small steps now beat a surprise later.

The whole of it

What it is

I once watched a neighbor spend an afternoon trying to explain his insurance policy to his wife. He kept drawing circles on a napkin. I understood the trouble, because these products are built from several moving parts at once.

A permanent life insurance policy, such as whole life or universal life, has two jobs. It pays a death benefit to the people you name. It also builds a cash value, a savings pot inside the policy that grows over time. The insurer holds that pot. You do not hold it, though you may be able to reach it.

A policy loan lets the owner borrow against the cash value. Here is the part that trips people up. The insurer is not handing you your own money. It lends you its money and keeps your cash value as collateral, which is a pledge that backs the loan. The borrower owes interest on that loan, and the policy still grows or stalls on its own terms.

Why do people like these loans? There is no credit check, no set repayment date, and the loan is generally not taxed when it is made. Under the tax code, a loan is not income, because the borrower has to repay it. That is the whole attraction. It is also where the traps are hidden.

How it works

If you have ever taken out a loan, you know the basic shape. The borrower gets cash now and owes it back with interest later. A policy loan follows that shape, with a twist. The policy does not require a repayment schedule. The borrower can pay it back, pay only the interest, or pay nothing at all.

That sounds friendly. Yet unpaid interest does not vanish. The insurer adds it to the loan balance, and then interest is charged on the bigger balance. The debt can grow quietly year after year. If the loan plus its interest ever grows larger than the cash value, the insurer can end the policy. The plan requires the owner to keep enough value in the contract to cover what is owed.

Now the tax side. The tax code treats a policy loan as a loan, not as income, so long as the policy stays in force. Money you take out as a withdrawal works differently. A withdrawal first returns your basis, the premiums you paid in, and only then touches the gain. Some policies are also classified as modified endowment contracts, often shortened to MEC. A policy gets that label when it is funded too fast under a test set by the tax code, the seven pay test. For a MEC, loans and withdrawals are taxed gain first, and an owner under age the current figure, which the official source publishes each year can also face a 10 percent additional tax on the gain. That is a very different set of rules from an ordinary policy.

The trap sits at the end. If a policy with a loan lapses or is surrendered, the loan is treated as paid out of the policy. The taxable amount is the loan plus any cash received, minus the basis. That is gain, and it is taxed as ordinary income. The owner may get a tax form showing income and still hold no cash at all.

The numbers, and where to find yours

I like a plan I can check with my own eyes, so let me point you to the places where your figures live.

Your insurer sends an annual statement. It shows the cash value, the surrender value, the loan balance, and the interest rate charged. Read it closely. The surrender value is what you would actually receive if you ended the policy, after any charges the contract applies. Your total premiums paid, less any amounts already taken out tax free, give you a rough basis. The insurer can confirm the exact figure if you ask.

Ask for an in force illustration, which is a printout that projects the policy forward under stated assumptions. Ask what happens if the loan keeps growing at the current rate. Ask whether the policy is a MEC. These are fair questions, and a good agent will not mind them.

For the rules themselves, the primary sources are the Internal Revenue Code and IRS guidance. Section 7702 of the code defines what counts as life insurance for tax purposes. Section 7702A covers modified endowment contracts. Section 72 covers how withdrawals and loans from those contracts are taxed. The IRS also publishes Publication 525, which explains taxable and nontaxable income. Any limits or ages set each year are shown on the official pages, and a tax professional can check them against your own policy.

A worked example

Let me tell you about a man I will call Walter. He is fifty eight and has paid into a whole life policy for twenty years. He paid $4,000 a year, so his basis is 20 years at $4,000 a year, which is $80,000.

The cash value has grown to $130,000. Walter needs money for a roof and for helping his daughter. He borrows $60,000 from the insurer at a 6 percent loan rate. Because the policy stays in force, he owes no tax on the loan. So far, so good.

Walter does not make payments. The interest on $60,000 at 6 percent is $3,600 in the first year. The insurer adds that to the loan, so the balance is $63,600. The next year the interest is $63,600 times 6 percent, which is $3,816, and the balance grows to $67,416. The debt keeps climbing.

Say ten years pass. Suppose the loan has grown to $110,000 and the cash value has fallen short of covering it, so the insurer ends the policy. The policy is treated as paid out. The loan is $110,000. Walter's basis is still $80,000. His taxable gain is $110,000 minus $80,000, which is $30,000.

Walter would owe ordinary income tax on that $30,000. If his tax rate is 22 percent, the bill is $30,000 times 22 percent, which is $6,600. He gets no cash with it, because the money was spent years ago. The insurance coverage is gone too.

Was Walter careless? No. He did what the policy allowed. He simply did not see the quiet climb of the loan. That is the lesson. Walter's story could have gone differently if he had paid the interest each year, which is $3,600, and kept the balance flat.

Where it goes wrong

I have found that the sad stories in this area share a pattern. They start with a good feeling and end with a letter nobody wanted.

The first snag is the lapse. When a policy with a large loan ends, the tax bill arrives with no cash attached. The second is the MEC surprise. An owner who funded a policy quickly may not know it is a MEC, and then a loan is taxed gain first, with a possible extra 10 percent tax when the owner is under the age set by law.

The third is the slow growth of the loan. Interest left unpaid compounds, and the cushion between the loan and the cash value shrinks. The fourth is a loan rate that is higher than the rate the policy credits to the money held as collateral. In that case the borrower pays more than the policy earns on that slice.

There is a fifth, and it is the quietest. A policy loan reduces the death benefit by the loan balance, because the insurer subtracts what is owed before paying the heirs. A family expecting $250,000 may receive far less.

None of this means a policy loan is wrong for everyone. It means the borrower should go in with eyes open, with the insurer's numbers in hand, and with a tax professional who has seen the actual contract.

Questions to answer before you leave this page

What is your policy's cash value today, and what is the surrender value after charges? How much have you paid in total, and what is your basis? Is the policy a modified endowment contract, and have you asked the insurer to confirm it in writing? What loan rate does the insurer charge, and what rate does it credit on the money held as collateral? If you borrowed and paid nothing, how large would the loan be in ten years, and would the policy still stand? What would your tax bill be if the policy lapsed with that loan outstanding? And who will you ask, a licensed tax professional or the insurer's own service team, to check these answers against your real contract?