Taking out a loan against your life insurance does not count towards taxable income. However, this will change if you abandon your policy or the policy expires and the amount owed exceeds the deposit. In this case, the loan becomes taxable. A Form 1099-R and you have to pay tax on the loan plus interest at your regular income tax rate.
The central theses
- A loan from a life insurance policy is not taxable as income as long as it does not exceed the premium payment for the policy.
- If you abandon your policy or your policy expires, the loan (plus interest) will be considered taxable income by the IRS at your normal income rate.
- While repayment of a loan is not mandatory, any debts outstanding upon the death of the insured will be deducted from the policy payout to the beneficiaries.
How Much of a Policy Loan is Taxable?
The money you borrow is not taxable as long as it equals the amount of insurance premiums you paid when the policy was terminated. A taxable amount is the amount of realized gain, that is, an amount you received from the present value of your policy less the net premium cost or the sum of the premiums paid less distributions received.
For example, let’s say you have life insurance with a cash value of $ 400,000. You paid $ 100,000 in rewards but have a balance of $ 300,000 on an outstanding policy loan with no distributions. When your policy expires, you will need to claim $ 200,000 as income.
This can be a problem for those whose interest was paid in dividends or the cash value of the policy rather than out of pocket. Out of pocket interest payments are not tax deductible steer have already been paid with this amount.
However, interest payments not made out of pocket often do not cover the entire interest amount due, so that compound interest added to the principal. If your loan is left untouched and accruing interest with minimal interest payments for decades when a taxable event occurs, you may end up owing tax on a balance much greater than what you originally borrowed.
Additional Policy Loan Considerations
Obtaining a policy loan is usually quick and easy. You don’t need to go through an approval process as you are borrowing against your own assets. You can use the funds as you wish. After all, you don’t have a repayment schedule or repayment date. In fact, you don’t have to pay it back at all.
If a policy loan is not repaid, the interest rate can significantly reduce the death benefit, which can put the policy at risk from not making money available to beneficiaries.
However, if the loan is not repaid before the death of the insured person, the insurance company will reduce the nominal amount of the insurance policy by the amount that is still owed when the death benefit is paid out.
If you repay the loan in whole or in part, you have the choice between regular repayments with annual interest payments, only annual interest or the deduction of interest from the present value. It is wise to at least make interest payments so that the policy loan doesn’t grow.
In the worst case, if the additional interest increases the credit value beyond the cash value of your insurance, your life insurance could expire and be canceled by the insurance company. In such a case, the policy loan balance plus interest will be considered taxable income by the IRS and the bill could be large.
Is a Life Insurance Loan Taxable?
Not really. Be careful though, as that will change if you abandon your policy or the policy expires and the amount owed exceeds the deposit. In this case, the loan becomes taxable.
What happens to the death benefit if a policy loan is not repaid?
If the loan is not repaid before the death of the insured person, the insurance company will reduce the nominal amount of the insurance policy by the amount still owed when the death benefit was paid out. In other words, if you are the policyholder, your beneficiaries get less when you die. So, pay back those loans.
What is a worst-case scenario regarding policy loans and taxes?
If the additional interest increases the mortgage lending value above the cash value of your insurance, your life insurance can expire and the insurance company can terminate it. In such a case, the policy loan balance plus interest will be considered taxable income by the IRS and the bill could be high.