Loans on Your Life Insurance Policy – What You Need to Know
When finances are rough, sometimes you might need to get creative about how you meet demands. Turns out your life insurance policy could be a source of relief. From withdrawals, partial and full surrender, to even life settlements, there are plenty of options to consider. However, right now, we’ll focus our attention on the possibility of taking out a loan. As you might expect, there are some pitfalls.
How a Life Insurance Loan Works
If you recently started your life insurance policy, don’t expect to be able to take out a loan for some time. Life insurances that build cash value, such as whole life and universal life, will build reserves through excess premiums plus earnings. Within the policy, these deposits are held in a cash-accumulation account. Through a loan, you can have access to it, potentially. If you have enough funds from the cash-accumulation account, you are normally allowed to borrow money from your issuer. In most cases, you will be allowed to borrow the amount in the reserves, minus interest.
The Good News
Depending on the policy, the loan may or may not be taxable. However, it is a “minefield” when it comes to these sorts of issues, with regard to taxes and life insurance loans.
For instance, even if your loan isn’t taxable, it could become so in certain situations. As we will see in the next section, if your policy lapses or is cancelled, it could have some tax implications. You would be advised to be absolutely clear on such matters; you don’t want to take out a loan and then find out you owe taxes on it.
Even though the loan might accrue interest, you will not have to make payments on it. This can certainly be an appealing factor, when times become rough. While there are further implications, this is a point that can give you some breathing room and flexibility.
The Bad News
Though you don’t have to make payments, there are some drawbacks. Keep the following points in mind if you are considering a loan on your life insurance policy:
o Reduced death benefit: If you take $100,000 out on a $500,000 policy, you are essentially working with a $400,000 policy. The value of the loan is subtracted, bringing the death benefit lower until it is paid. If not, beneficiaries will receive the reduced amount.
o Loss of policy: As interest gains, your policy could potentially lapse if the premiums are insufficient to maintain the death benefit. This can be taxable if the insurance is surrendered; you might now be paying taxes on the borrowed interest. In Summary…
A loan on your life insurance can be a good idea, depending on your needs.
Make sure you are aware of the reduced death benefit. For example, if your policy is for the right amount, and you end up taking a substantial loan, this might become insufficient for your needs. In essence, you are removing coverage that life insurance provides. Do your research on your policy. You don’t want to pay high interest or find out that it’s taxable. Make sure you consult a professional before diving into a loan.