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One of the reasons some people buy cash value life insurance is the potential to borrow money from the policy later on. When you bought your insurance policy, the insurance agent may have touted that you would be borrowing your own money and paying yourself back. Insurance agents and companies may promote loans as an easy way to receive tax-free money from your life insurance policy. However, policy loans are more complicated than they appear. Life insurance policy loans need to be reviewed and monitored. If a policy loan is not monitored, a policy could slowly deteriorate, losing the minimum cash value needed. This can leave you with the unpleasant choice of making substantial loan repayments or having a large phantom income tax gain. What Is a Life Insurance Policy Loan?Policy loans are available on most permanent cash value life insurance policies. Life insurance policy loans are not the same as other loans: Policy owners are not required to repay the loan. Keep in mind, the insurance company will charge interest on the policy loan. If you borrow money from your life insurance policy, you are borrowing your own money. It is essentially an advance of money that could be received from the policy either through a surrender of the policy or the payment of the death benefit. It is money that you, or your beneficiary, would have received anyway. The policy’s cash value acts as collateral for the policy loan. If you never pay back the policy loan during your lifetime, the amount is deducted from the death benefit when you pass away—meaning that your beneficiaries will receive less and essentially repay the loan. In Board of Assessors v. New York Life Insurance Company (1910), U.S. Supreme Court Justice Oliver Wendell Holmes wrote, “The so-called liability of the policyholder never exists as a personal liability, it is never a debt, but is merely a deduction in account from the sum the plaintiffs (the insurer) ultimately must pay.” How Does a Life Insurance Policy Loan Work?Life insurance policy loans are available on life insurance policies where there is sufficient cash value to borrow against. (Term life insurance has no cash value.) The available loan amount will be a percentage of the cash value. You must pay interest on the policy loan. To initiate a policy loan, you’ll need to contact your life insurance company. Before taking out a policy loan, find out what will happen to the components of your policy after the loan. You can do this by requesting an in-force policy illustration that will reflect the policy’s value based on your plans—whether you’ll borrow more money, repay the loan or maintain the loan. Be sure the in-force illustration also reflects whether you will be paying interest on the loan out of pocket or if you will be borrowing interest as well. And review the following terms of the loan. The insurance company will charge interest in advance or in arrears. Interest in advanceInterest in advance means the insurance company charges interest for the full year. This assumes that the loan is continued for that policy year. If the loan is taken out in the middle of a policy year, interest is charged for the remainder of the policy year at the time the loan is taken out. Interest in arrearsInterest in arrears means the insurance company charges interest at the end of the policy year. Interest accumulates daily. If a loan is taken out in the middle of a policy year, interest starts to accumulate that day. If you make a loan repayment in the middle of the policy year, this would decrease the daily loan interest amount, thereby decreasing the loan interest due at the end of the policy year. The interest rate on a life insurance policy loan could be fixed or variable. Fixed interest rates are guaranteed, so you will know in advance what your loan interest will be each year. Variable interest rates can change each year. Variable interest rates will be disclosed on your policy’s annual statement and with premium notices when loan interest is due. The money you have taken out can still earn gains. The insurance company will pay you interest (or dividends) on the amount borrowed, although this rate is usually lower than the interest rate credited to the remainder of cash value. On certain policies, you will receive the same interest rate. Whole life insurance policies use the term “recognition” to define how much interest is credited to the amount of the cash value that is loaned out. If your life insurance company uses the non-direct recognition method, you will receive the same dividend on your all cash value. If your company uses the direct recognition method, you may receive a lower dividend on the amount of your cash value that constitutes the loan. Whole life policies may also have an optional automatic premium loan provision. If you don’t pay your premium due, it is automatically deducted from the cash value through a policy loan. Keep in mind that interest on a policy loan is generally not tax-deductible. How to Monitor a Life Insurance Policy LoanThe insurance company will not require you to pay back the loan balance. Nor do they provide any loan repayment schedule. You have the option each year to pay loan interest out of pocket or to borrow the interest. If you choose to borrow the interest, the loan balance will compound, which means that the interest due each year will compound. It’s important to request an in-force policy illustration annually to determine the impact of a policy loan. Your request should include the following scenarios along with any others that reflect your plans:
Why Is a Life Insurance Policy Loan Risky?An in-force policy illustration can help you determine how long your policy will remain in force while the loan is out. You will find that the larger the loan, the more impact it will have on your policy. For example, with an initial policy loan of $50,000 and a loan interest rate of 8%:
As you can see, this rapidly increases the policy loan balance. Here’s how it works: With a typical permanent life insurance policy, the cash value increases every year. This reduces the total risk to the insurer because it will pay out only the death benefit when you pass away and absorb the cash value. Mortality costs—the actual cost of insurance for you—are also increasing each year because you get older. But that increase is usually offset for the insurer by the decreasing amount at risk. If you’ve taken out a loan from the cash value, the lower cash value will result in lower earnings. If your premium payments aren’t enough to cover the mortality cost and other fees, the insurer will take it from your cash value. Now your cash value is being depleted by multiple demands—the loan, lower earnings and fees. And if the cash value goes to zero the policy will terminate, unless you make an infusion of premium. If the policy terminates, you’ll get dinged by an income tax bill on the loan money you took. Calculating Taxable Income from a Life Insurance Policy LoanHere’s how to calculate the potential gain in the policy that would be subject to income tax:
Example: If a life insurance policy terminates with a loan balance of $100,000 and a cost basis of $50,000, the taxable gain would be $50,000. Please note that the above example is a general rule and may not apply to every situation. You should consult your tax advisor to confirm whether you have a taxable gain. Your life insurance company will be able to provide you with the cost basis, along with the gain that they will report to the Internal Revenue Service as 1099 income. While a life insurance policy loan can provide you with immediate funds, it can have a number of drawbacks. Know what you’re getting into before you take the cash.
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Cash surrender value is money an insurance company pays to a policyholder or an annuity contract owner if their policy is voluntarily terminated before maturity or an insured event occurs. This cash value is the savings component of most permanent life insurance policies, particularly whole life insurance policies. It is also known as policyholder's equity.
Cash surrender value applies to the savings element of whole life insurance policies payable before death. However, during the early years of a whole life insurance policy, the savings portion brings very little return compared to the premiums paid. Cash surrender value is the accumulated portion of a permanent life insurance policy's cash value that is available to the policyholder upon surrender of the policy. Depending on the age of the policy, the cash surrender value could be less than the actual cash value. In the early years of a policy, life insurance companies can deduct fees upon cash surrender. Depending on the type of policy, the cash value can be available to the policyholder during their lifetime. It is important to note that surrendering a portion of the cash value reduces the death benefit. Depending on the age of the annuity, charges may apply to partial and full surrenders. Taxes are deferred until surrender, at which point an additional premature withdrawal penalty may apply depending on the age of the annuitant. In most whole life insurance plans, the cash value is guaranteed, but it can only be surrendered when the policy is canceled. Policyholders may borrow or withdraw a portion of their cash value for current use.
The cash surrender value of an annuity is equal to the total contributions and accumulated earnings, minus prior withdrawals and outstanding loans. A policy's cash value may be used as collateral for low-interest policy loans. If not repaid, the policy's death benefit is reduced by the outstanding loan amount. Loans are tax-free unless the policy is surrendered, which makes outstanding loans taxable to the extent they represent cash value earnings. The cash value and the surrender value are two different things. When determining your cash surrender value, you must consider any fees your company will charge for removing your money funds. In order to determine how much money you will receive in a cash surrender, you must add up all the payments you have made to the policy and then subtract the fees and possible penalty withdrawal charges. For example, suppose you take out a whole life insurance policy for $100,000. You make 10 years of payments and build up a cash value of $10,000. However, the surrender change will cost you 30% of the cash value. You will have to pay $3,000 in charges, and you will only get $7,000 out of the cash surrender. The good news? You most likely won't pay taxes on the cash surrender because it is considered a return of premiums on your account and not taxed.
Don't overestimate your surrender or cash value, which is not reflective of the amount of coverage you have taken out for the death benefit. A cash value is tied to the policy as a benefit to help offset the rise in premiums as you grow older and offers policyholders access to money they can borrow. In universal life insurance plans, the cash value is not guaranteed. However, after the first year, it can be partially surrendered. Universal life policies typically include a surrender period during which cash values can be surrendered, but a surrender charge of up to 10% may be applied. There is no surrender charge when the surrender period ends, usually after seven to 10 years. Policyholders are responsible for the taxes on portions of the surrendered cash values that represent cash value earnings. In either case, sufficient cash value must remain inside the policy to support the death benefit. With whole life insurance plans, loans are not considered cash surrenders, so the level of cash value is not affected. With universal life insurance policies, cash values are not guaranteed. If cash value growth falls below the minimum level of growth needed to sustain the death benefit, the policyholder must put enough money back into the policy to prevent it from lapsing.
Whole, universal, variable universal, and indexed universal life insurance often have a cash value component to them.
It depends on your individual financial situation. If you have maxed out contributions to your retirement account, have a cash nest egg saved for emergencies, and you can afford the monthly premiums on a whole or universal life insurance with a cash value benefit, they may be a good choice. However, if you cannot afford a lifetime of high premiums and you are struggling to save for retirement, these accounts are not recommended as a tool for investment.
In many cases, it is possible to use the cash value in your account to pay your premiums. By doing so, you keep the coverage in place for your beneficiaries. You can also take out loans against your cash value, and keep the policy. If you cash out the value, your death benefit may be reduced.
While not always advisable, you may be able to sell your life insurance policy to a third party for cash. There are only certain kinds of life insurance that even offer a cash value component as whole and universal life. When you surrender the cash value in your life insurance policy, the transaction will be terminated. If you borrow from the cash value, your policy stays in place. If you surrender your policy, you lose the cash benefit, and you will likely be hit with fees and other charges, especially if your policy is relatively new with little equity built into it. In addition, if you surrender your life insurance policy, it will impact your listed beneficiaries. Whole life insurance guarantees a cash value but you can only surrender it when you cancel your policy. Universal life insurance tends to be more flexible with its cash value, allowing policyholders to partially surrender the cash after the first year of holding the policy. Overall, if you surrender your policy in order to tap its cash, you will not receive the actual cash value of the policy but its surrender value, which most likely will be substantially less than the full policy. |