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A life insurance policy has value, and can be used as collateral to secure a loan — but securing a loan with a life insurance policy can leave you vulnerable to unexpected financial and tax consequences. Carefully weigh the pros and cons of this type of loan before signing a loan agreement.
A life insurance policy loan is extended by your insurer and is secured by the cash value of your life insurance policy. It cannot exceed the amount of your cash value. If your collateral is in an investment account, your insurer will take it out as soon as you sign the loan agreement, and move it to a secure account that is insulated from the likelihood of investment losses. You don't even have to pay back the loan if you don't want to — but whatever amount you fail to pay by the time you die will be deducted from your beneficiary's death benefit.
As of the time of publication, your interest rate should be between 5 percent and 9 percent of the loan amount. If you decide not to repay the loan during your lifetime or to defer repayment until later, the amount of the unpaid interest will be added to the principal of the loan, and further interest will accumulate on that amount. Your policy will be terminated if your loan principal and interest ever exceed your policy's cash surrender value, unless you pay additional amounts. If your collateral was moved from an investment account to a secure account, your insurer may charge you for the amount by which the investment account earnings exceed the secure account earnings. If you receive dividends from your life insurance policy, these dividends will probably decrease in proportion to the amount of collateral that was moved to a secure account.
Loan proceeds are not considered taxable income, but you generally can't deduct interest you pay on a life insurance policy loan from your taxable income. If you surrender your policy or it lapses before you have fully repaid the loan, the IRS will treat the amount outstanding on your loan as an amount received from your insurer. If the total of that "amount received" plus any other amounts you receive from your insurer exceeds your net premium cost, the amount of the excess is treated as taxable income subject to ordinary income tax rates. If you have allowed unpaid interest to accumulate in your account for decades, your taxable income could be suprisingly high.
Suppose your life insurance policy has a cash surrender value of $300,000, and you have paid premiums of $130,000. Suppose further that you have an outstanding policy loan amount of $150,000, and you surrender your policy to the insurer for $25,000. As long as your insurer has paid you no distributions from the policy, your taxable income as a result of surrender is calculated as $25,000 plus $150,000 — which comes to $175,000 — minus $130,000. That equals $45,000 that's taxable, even though the actual income generated by the surrender was only $25,000.