Life insurance policies have evolved into complex financial instruments that no longer simply share risks between an insurance company and the insured. Policyholders now have more control over the policy, which they can use to satisfy new needs and desires.
In times of need, a policyholder can use their life insurance policy as collateral to take out a loan issued by their insurance company – known as a policy loan.
However, policy loans are one of the most complex, misunderstood, and misused components of a life insurance policy. They are like termites, and if left alone, they will eventually cause an insurance policy to terminate or lapse. This could result in the insured having no coverage and, possibly, a huge tax penalty.
According to Law and the Life Insurance Contract by Muriel Crawford and William Beadles, the term “policy loan” is a misnomer – an inappropriate designation).
By definition, a loan is the transfer of money by one person – the creditor – to another person – the debtor – upon agreement that the debtor will return to the creditor an equivalent sum at a later date, plus interest.
A policy loan is not truly a loan because the policy owner does not agree to repay the money transferred to them by the insurer, although interest is still charged.
It is an advancement of money that the insurer must eventually pay out under the terms of the policy. Thus, a policy loan does not create a creditor-debtor relationship between the insurer and the policy owner.
U.S. Supreme Court Justice, Oliver Wendell Holmes, came to the same conclusion in Board of Assessors v. New York Life Insurance Company, one of the leading court decision involving policy loans.
“The so-called liability of the policyholder never exists as a personal liability, it is never debt, but is merely a deduction in the account from the sum the plaintiff (i.e., insurer) ultimately must pay,” said Holmes in 1910.
Policy loans are more complicated than agents claim them to be, with the promises of premium-free life insurance. When in reality, borrowing to pay premiums reduces the death benefit.
Some companies even suggest to clients – who have an underperforming policy – that a policy loan could support their faltering policy. But this actually robs “Peter” to pay “Paul”, and the policy owner eventually must make up the difference.
Out-of-control policy loans can erode a life insurance policy over time, eventually draining all the death benefits as well as saddling the policy owner with a substantial tax bill.
The basic calculation for the potential taxable income impact would be to add the net cash (surrender) value plus any dividends received (either prior or accumulated) and the loan balance at the time of surrender.
From that sum, subtract the basis (sum of premium) paid into the policy and that will be the gain in the policy that is subject to income tax.
Please note that this is a rule of thumb and may not apply in all cases depending on ownership, transfer, if it held inside a qualified plan, etc.
However, this should give you a starting point.
An insurance company will usually be able to provide you with the basis and other necessary figures, as well as the potential gain, typically reported to the Internal Revenue Service on a 1099 form.
Please note that this is not tax advice. For tax advice, please consult your tax advisor.
Tony Steuer is an author and advocate for financial preparedness. Tony Steuer, CLU, LA, CPFFE, helps people make sense of the financial world in a way that’s easy for them to understand. His books including, “GET READY!,” “Insurance Made Easy,” and “Questions and Answers on Life Insurance,” have won numerous awards. Tony is the founder of the GET READY! Initiative which includes the GET READY! financial organization system, the GET READY! Financial Preparedness Club, GET READY! Podcast, and the GET READY! Financial Principles, a best practices playbook for the financial services industry. Tony served as long-term member of the California Department of Insurance Curriculum Board. Tony is regularly featured in the media including the New York Times, the Washington Post, Fast Company, and other media. He has also appeared as a guest on television shows, such as ABC’s “Seven on Your Side.” Visit https://tonysteuer.com/ to join the GET READY! Financial Preparedness Club and access free resources.