Are life insurance loans taxable?
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There are several advantages associated with buying a permanent cash value life insurance. While you are most definitely going to pay higher premiums for a seemingly lower death benefit compared to a term policy, the cash values that are accrued in the cash account of a permanent plan turn the life policy into a product that offers both a death and a living benefit. This living benefit can be accessed while the policy is active in most cases, which is called a cash account loan in the industry. Money paid out in the form of a policy loan can be used for virtually any purpose, whether it is to buy a home to or pay for college tuition. Start comparing life insurance rates now by entering your zip code in our FREE tool above!
When agents are selling a permanent life insurance policy, much of the focus is placed on the benefits of buying a policy that stays in force for life and that accrues cash values as it earns interest. These are huge benefits that should be explained to prospective buyers, but it is also important to educate the client on some of the potential tax implications for taking life policy loans out. If you want to be sure that you are learning everything that you need to know before you put your cash values to use, read this guide to the taxation of life insurance policy loans and you can then decide if loans are a good idea.
Why can you take a loan against cash value life insurance?
Term insurance and cash value insurance differ in a couple of major ways. One of the major differences is that a permanent plan has a cash value component that can accrue interest over the life of the policy as premiums are paid.
Only a portion of the premiums that are paid go towards the actual cost for pure life insurance, but the other portion goes to maintenance fees and into the cash account.
Where the money will be invested will depend upon the type of permanent policy that you choose. Since there is not cash account where premiums are deposited in a term insurance policy, there is no opportunity to take out a loan. Where there is a savings component, there is a right to request loans or even a withdrawal. This is why there are policies that you can take out loans on and policies that you cannot.
When is it a good time to request a life insurance loan?
Now that you understand why term insurance does not have a loan feature and permanent insurance does, the next step is to determine when it makes sense to borrow against your cash values. Before you jump at the opportunity to sign the loan request when you discover there are thousands of dollars sitting in your cash account, you need to think twice.
There are definitely pros and cons to borrowing against life insurance, but in some scenarios taking a loan is the entire reason that you chose a permanent plan in the first place. You should definitely meet with your financial adviser and research tax implications so that you know all of the details before you make a final decision because once you take a loan out, you will be charged interest. Here are scenarios where taking a loan out may make a great deal of sense:
- You Need Quick Cash and You Cannot Qualify For a Personal Loan
Some lending requirements have gotten very strict. This is especially true when you are requesting a personal loan with no collateral. If you have credit problems or you are finding that it is hard to qualify for a traditional loan through your bank, you could turn to your life policy in the meantime. This will give you the immediate cash you need, and you can pay back the loan in full once you qualify for the traditional loan you have been searching for.
- The Loan Options Available to You Come With High Interest
If the only loan options that are available to you come with high interest, a life insurance loan could be a very competitive option. Taking out frequent life insurance loans could pose problems for you if you want to keep your policy active, but as long as you have every intention of paying your back by paying back the loan and the interest, you should not have issues. One of the reasons why life loans are a good alternative is because the interest is low and there are not repayment due dates or terms.
- Keeping Your Policy Active During Tough Times
Many policyholders do not know that they can keep the life policy active by requesting out a loan when there is a loan available. If the only option is to allow your policy to lapse, avoid losing out on the coverage that you intended to have for life and request a loan for the annual premium amount. This helps keep you covered and gives you time to come up with the funds for repayment.
What are the tax implications of taking out life loans?
There is a huge misconception that you are borrowing from yourself when you take out a cash loan. When you believe this, it is reasonable to believe that you will not face any tax consequences when you sign the paperwork. This could be further from the truth, but to understand why you need to understand how loans really work.
Who are you really borrowing against?
While many agents say you are borrowing your own money, in reality you are borrowing money from your insurance company and then putting up the cash values of your policy as collateral. You still own your policy, it still offers the same death benefit, you just have less equity in the policy than you used to. So you are not taking a loan from yourself, but you are paying yourself back as you repay the loan amount and the interest.
What happens if you do not make payments?
Your policy will only remain active for a limited amount of time when you take a loan and you choose not to repay it. One of the reasons for this is how the policy is organized. As you pay your premiums, the cost of pure life insurance goes up. Your payment only reason your premiums are level is because of the value in your cash account that can be applied to keep the policy active. If money is not there, interest will accrue and the loan balance will eventually become equal to the cash value. When this happens, the policy will lapse. This is why it is so important to understand loans and to understand how to avoid a lapse.
Tax Consequences of Permanent Life Without a Loan
Payouts to beneficiaries are not taxable, but contrary to popular believe, even cash surrenders of a policy with no loan are taxable.
Many people believe that life insurance payouts are tax-free. This is a misconception that needs to be cleared up before you find out about the tax implications of a loan.
To understand this concept here is an example: You have paid $50,000 in premiums into your whole life policy. This policy has a surrender value of $105,000. When the surrender is paid out, the first $50,000 is not taxable. The remaining $65,000 will be added to your taxable income for the year.
The Tax Implications of a Life Loan
Now, if you have a loan on your life insurance policy, the tax consequences become even more complicated. When you borrow against your permanent life plan, in most cases the loan proceeds will not be taxable. The only instance where the loan proceeds will be taxable on an active contract will be when there is a Modified Endowment Contract (MEC). This is because a MEC has an income-out-first rule that says that the loan that comes out will be considered taxable income first. These types of contracts are subject to the common 10% tax penalty during the year when the loan was requested.
If your policy were to accidentally terminate because you cannot pay the premiums that are needed to keep it active, the loan that is outstanding will be a taxable gain. This is why you really need to keep an eye on your loan balance and your updated policy illustrations so that you do not miss a repayment that could be the difference between a penalty and keeping your coverage.
If you are ready to buy insurance, it is time to price the cost of premiums. There are laws surround permanent insurance, but every company charges their own unique rates. To find the best rates, use a comparison tool online that will help you find out what handfuls of companies will charge from home. By doing this, you can window show without leaving your home or your business office. Compare life insurance rates now by using our FREE tool below!
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