Are Life Insurance Policy Loans Taxable?

Published: 29th June 2007
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Life Insurance Policies are another way to accumulate tax deferred wealth and it is possible to borrow against the cash value. But are Life Insurance Policy Loans Taxable?

A permanent life insurance policy has the added feature of accumulating a cash value over the life of the policy. This cash value can be used as security for a Life Insurance Policy loan. It is considered as security for the loan because it does not negate the coverage afforded by the policy as long as the loan is repaid. This fact impacts the taxation picture because it means that you are not actually receiving a distribution of the cash value.

Although the premiums paid on Life Insurance Policies are not allowable as a tax deduction, the earnings in the policy are not taxed either. In this manner, the policy acts similar to other forms of tax shelters such as IRA or 401k retirement accounts. Also, the death benefit that would be paid to your beneficiary upon your demise is normally not subject to taxation either. However, should you surrender your policy and take the cash value, the proceeds above the amount of your premiums would be subject to taxation.

If you borrow against the cash value of the policy, however, it is not really a distribution. It is not considered income because the amount will have to be paid back eventually and also you will have to pay interest on the loan. Many people fail to understand this principle and feel like they are borrowing their own money and wonder why they are paying interest.

The answer is that they are not borrowing their own money at all. Their money is still in the Insurance Account and still performing the intended function of providing security in case of the death of the policy owner. It would also still be accumulating earnings in accounts where the cash value is invested. It is not considered income anymore than a Mortgage loan or auto loan would be considered income for the purposes of taxation.

If failure to repay the loan leads to a lapse or cancellation of the policy, this will have tax implications. Since the cash value of the policy would, in a sense, be used to repay the loan, the amount paid would be considered income as would any additional funds distributed upon the surrender of the policy. Life Insurance taxation issues are even more of a minefield of complex regulations than even the norm for other types of investments. You are going to need to touch base with your tax expert and Insurance Agent to navigate this minefield successfully.

Barry Waxler provides financial planning in San Diego through UFCAmerica.com.


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