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One of the reasons some people buy life insurance with cash value is the ability to borrow policy money later. When you purchased your insurance policy, the insurance agent may have announced that you would borrow your own money and pay yourself back.

Insurance agents and companies can promote loans as an easy way to receive tax-free money from your life insurance policy. However, policy loans are more complicated than they appear.

Policy loans should be reviewed and monitored. If a policy loan is not monitored, a policy could slowly deteriorate, losing the minimum cash value necessary. This can leave you with the unpleasant choice of making substantial loan repayments or having a large phantom tax gain.

What is a life insurance policy loan?

Policy loans are available on most life insurance with cash value Strategies. Policy loans are not the same as other loans: policyholders are not required to repay the loan. Keep in mind that the insurance company will charge interest on the policy loan.

When you borrow money from your life insurance police, you borrow your own money. Essentially, it is an advance of money that could be received from the policy either through a surrender from the policy or through the payment of the death benefit. It is money that you or your beneficiary would have received anyway. The cash value of the policy serves as collateral for the policy loan.

If you never repay the policy loan while you are alive, the amount is deducted from the death benefit when you die, which means your beneficiaries repay the loan.

In Board of Assessors v. New York Life Insurance Company (1910) United States Supreme Court Justice Oliver Wendell Holmes wrote: account deduction of the amount that the claimants (the insurer) ultimately have to pay.

How does a life insurance policy loan work?

Life insurance policy loans are available on life insurance policies when the cash value is sufficient to borrow. The available loan will be a percentage of the cash value. You must pay interest on the policy loan.

To initiate a policy loan, you must contact your life insurance company. Before taking out a contract loan, find out what will happen to the elements of your contract after a loan. You can do this by requesting a live illustration that will reflect the policy loan based on your plans whether you will borrow more money, repay the advance, or keep the advance.

Make sure that the current illustration also indicates whether you will be paying interest on the loan out of pocket or whether you will be borrowing interest as well.

And review the following loan conditions.

The insurance company will charge advance or late interest:

Interest in advance.The insurance company charges interest for the entire year. This assumes that the loan is maintained for that insurance year. If the loan is taken out in the middle of an insurance year, interest is charged for the remainder of the insurance year when the loan is taken out. If a loan repayment is made during the insurance year, the insurance company will generally not give any credit or refund on interest paid in advance.

Interest in arrears. The insurance company charges interest at the end of the insurance year. Interest accrues daily. If a loan is taken out in the middle of an insurance year, interest begins to accrue on that day. If you repay an advance in the middle of the insurance year, it will reduce the amount of daily advance interest, thereby lowering the advance interest due at the end of the insurance year.

The interest rate can be fixed or variable. Fixed interest rates are guaranteed, so you will know in advance what your loan interest rate will be each year. Variable interest rates may change each year. Variable interest rates will be disclosed on your annual policy statement and with premium notices when interest on the loan is due.

The money you have withdrawn can still pay off. The insurance company will pay you interest (or dividends) on the amount borrowed, although this rate is usually lower than the interest rate credited on the remainder of the cash value. On some policies, you will receive the same interest rate.

Whole life insurance policies use the term “acknowledgment” to define the amount of interest credited on the amount of cash value that is loaned. If your life insurance company uses the non-direct accounting method, you will receive the same dividend on your entire cash value. If your business uses the direct accounting method, you may receive a lower dividend on the amount of your cash value that constitutes the loan.

Whole life insurance policies may also have an optional automatic premium loan provision. If you do not pay your premium due, it is automatically deducted from the cash value through a policy loan.

Remember that interest on a policy loan is generally not tax deductible.

How to Monitor a Life Insurance Policy Loan

The insurance company will not ask you to repay the loan balance. They also do not provide a loan repayment schedule. You have the option of paying the interest on the loan out of pocket or borrowing the interest each year. If you choose to borrow the interest, the loan balance will be compounded, meaning that the interest owed each year will be compounded.

It is important to ask for a illustration of the current policy annually to determine the impact of a policy loan. Your request should include the following scenarios as well as any others that reflect your plans:

Full repayment of the policy loan

Pay premiums and interest out of pocket

Borrowing future premiums and loan interest

Show what happens if your current premium payments stay the same

Display of the premium required to endow the contract at maturity

Any other action you are considering, such as making a partial withdrawal or changing your dividend option

Why is a life insurance policy loan dangerous?

The illustration of the current policy will help you determine how long your policy will remain in force. You will find that the larger the loan, the more impact it will have on your policy.

For example, with an initial policy loan of $ 50,000 and an interest rate of 8%, the loan interest for year 1 will be $ 4,000. If you borrow the interest on the loan, your loan balance will increase to $ 54,000 (original loan amount of $ 50,000 plus loan interest of $ 4,000). The interest on the loan in year 2 would increase to $ 4,320. The loan balance would increase to $ 58,320 if loan interest is borrowed again (loan balance of $ 54,000 plus loan interest of $ 4,320). As you can see, this quickly increases the policy loan balance.

Here is how it works:

On a permanent life insurance policy with a cash value, the cash value increases each year. This reduces the total risk to the insurer, as they will only pay the death benefit upon your death and absorb the cash value. Mortality costs – the actual cost of insurance to you – also increase each year as you get older. But this increase is generally compensated for for the insurer by the decrease in the amount at risk.

If you took out a loan from the cash value, the lower cash value will result in lower income. If your premium payments are not enough to cover mortality and other costs, the insurer will take them out of your cash value. Now your cash value is depleted by multiple demands: the loan, lower income, and lower fees. And if the cash value drops to zero, the policy will be terminated, unless you inject the premium.

If the policy ends, you’ll be shocked by an income tax bill on the loan money you took out.

Calculation of taxable income from a policy loan

Here’s how to calculate the potential gain of the contract that would be subject to income tax:

1. Add the net cash value (redemption), any dividends received (past or accrued) and the outstanding loan balance.

2. Subtract the base cost (sum of premiums paid into the policy).

Example: If a life insurance policy ends with a loan balance of $ 100,000 and a base cost of $ 50,000, the taxable gain would be $ 50,000.

Please note that the example above is a general rule and may not apply in all situations. You should consult your tax advisor to confirm if you have a taxable gain.

Your life insurance company will be able to provide you with the base cost, as well as the gain that they report to the Internal Revenue Service as 1099 income.

While a policy loan can provide you with immediate cash, it can have a number of disadvantages. Know what you are getting into before you take the money.

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