Beware Of Life Insurance Policy Loans


Earlier this week I saw the following comment on Facebook;

Policy Loan

I can understand, and honestly sympathize, with the lady who made this comment.  However, rather than prove that her insurance company is crooked, she is just showing her own ignorance of how life insurance works.

Unfortunately, the financial mistakes we make when the kids are home can come back to haunt us during our retirement years.

Twenty seven years ago, I started my career with the life insurance company that she is complaining about.  I spent 5 years with them.  During that time I studied and earned my Chartered Life Underwriter, CLU, designation.

(At that time, the CLU designation was the highest academic/professional designation that could be earned by someone studying life insurance.  There was another standard, Million Dollar Round Table, that was considered even more prestigious but it rated someone based on their ability to persuade large numbers of people to buy insurance and not on how much they knew and understood how life insurance can be used.)

I cannot, personally, speak to the character of that life insurance company in the 1970s but I can promise that when I worked for them from 1987-1992, as a company, they were nothing but honest.

However, having said that, I did know some less than honest insurance agents.  (When the company caught them, they were terminated and customers were made whole, but that was only after those individual “crooks” were discovered.)

This lady’s anger, while justified, illustrates the importance of knowing how your life insurance policy works before you do anything.

When you bought your cash value life insurance, you may have been told, by your insurance agent, that your cash value would grow “tax-free.”

That is incorrect.  The money, that is sheltered in your life insurance, or annuity, grows “tax-deferred” only as long as it remains within your life insurance policy or annuity.  Once you take possession of the money, during your lifetime, it becomes taxable income.  (Unless you spend the money on IRS approved expenses, like Long Term Care.)

The frustration, and feeling of violation, that the lady in question is feeling is genuine but it is of her own making.  She failed to understand two principles of life insurance.

LIFE INSURANCE MUST RESULT IN A DEATH BENEFIT TO REMAIN “TAX-FREE”

The money that is placed within a life insurance policy is technically money that is saved to provide a “tax-free” death benefit to a named beneficiary.  Once that policy terminates in any way, other than a death benefit, it produces taxable income.

If her life insurance company reported taxable income to the IRS, it is likely that she either surrendered, or lapsed, her life insurance policy.  Since the policy did not end with a death benefit, all income, above the amount she paid in premiums, is taxable, just like interest earned at the bank, in the year the policy ends.

A tax professional will help you, if you have made a similar mistake, find a way to spread the tax liability over 5 years.

LIFE INSURANCE LOANS SHOULD BE REPAID

Some life insurance agents are keen to tell you, “You can access your money, completely tax-free, with a policy loan that you do not have to pay back.”

Like a statement from a politician, that remark is technically true, as far as it goes.  However, it does not tell the entire truth.

First, as discussed above, in order for the cash within a life insurance policy to be paid “tax-free” the policy must result in a death benefit, or proceeds used to pay for approved Long Term Care expenses.  If the policy ends in any other way, all of the proceeds, from the life of the policy, that exceed the amount that was paid in premiums, is taxable income.

Second, most policy loans accrue interest.  It is true that you are not required to pay back the money that you borrow.  However, if you choose not to pay back the principle, plus interest, the loan will continue to accrue interest.  The amount of the interest will be added to the amount of your loan.

Eventually, it is possible, if you live long enough, that the interest payment alone could exceed any positive interest or dividend payments that your life insurance policy generates on your cash value.

When that happens, you will need to choose between two options.

  1. Your insurance company will send you a bill for both the policy premium and interest payment.
  2. Your policy will lapse.  Since it did not end in a death benefit, all the interest earned over the years will be considered taxable income in the year your policy lapses.  (Even if you spent the money 44 years ago.)

MORAL

The lesson that can be learned from this person’s experience is that you should always think twice before you take a loan from your life insurance policy.

If you have no option but to take a loan from a life insurance plan, understand that at that point you are committing yourself to either continue to pay premiums for your entire life or pay the loan back along with any interest.

It may be a better option for you to repay a life insurance policy loan and interest than it would be to borrow money from the bank.  That is because the interest rate that life insurance companies charge is often less than what is available at the bank.

In addition, if you look at it one way, you are actually paying the interest to your beneficiaries.

POTENTIAL SOLUTION

I know that college funding is often how people use life insurance.

It is a wonderful tool to use if the insured dies before the child is eligible for college.  However, life insurance, as a college funding tool can be a nightmare if the insured cancels the policy after the child graduates.

If you, innocently, used “tax-free” policy loans to help your child through college, and there is still money left in the life insurance policy.  If you no longer need the death benefit, talk to your local insurance professional about something called a, “1035 Transfer of Assets.”

The 1035 Transfer of Assets allows you to transfer the cash value of your life insurance policy into a tax-favored annuity without you being charged with a taxable distribution.

Talk to your tax professional.   The 1035 Transfer of Assets may help you avoid some, if not all, the income taxes that have accumulated in your account over the years.

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