What Are the Tax Implications of a Life Insurance Policy Loan?

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What Are the Tax Implications of a Life Insurance Policy Loan?

A borrowing against your life insurance policy does not constitute taxable income. That changes if you surrender your insurance or it expires, and the amount owing exceeds the amount put in. The loan then becomes a taxable event. A Form 1099-R is produced, and you must pay tax at your usual income tax rate on the loan plus interest.

Key Takeaways

  • A loan from a life insurance policy is not taxed as income provided it does not exceed the amount paid in premiums for the policy.
  • If you surrender your insurance or it expires, the IRS considers the loan (plus interest) to be taxable income at your regular income rate.
  • While loan repayment is not required, any amount owed upon the insured’s death will be deducted from the insurance payout to beneficiaries.

How Much of a Policy Loan Is Taxable?

The money you borrow isn’t taxed as long as it’s equal to or less than the total of your insurance premiums when the policy expires. A taxable amount is equal to the amount of the realized gain, which is any money you earned from the cash value of your insurance less the net premium cost, or the sum of premiums paid less distributions received.

Assume you had a life insurance policy with a cash value of $400,000, for example. You paid $100,000 in premiums but still owe $300,000 on a policy loan with no dividends. If your coverage expires, you must claim $200,000 as income on your taxes.

This may be a concern for people who paid their interest using dividends or the cash worth of their insurance rather than out of pocket. Because out-of-pocket interest payments are not tax deductible, taxes on that amount have already been paid.

  Tax Relief Definition

However, non-cash interest payments often do not cover the total amount of interest payable, resulting in compound interest being added to the principal. If your loan stays untreated and accrues interest for decades with just minor interest payments made when a taxable event happens, you may wind up paying taxes on a sum that is far more than what you borrowed.

Other Considerations for Policy Loans

Obtaining a policy loan is typically fast and simple. Because you are borrowing against your own assets, you do not need to go through an approval procedure. You are free to spend the money anyway you see fit. Finally, you don’t have a repayment plan or a due date. You are not required to repay it in any way.

If a policy loan is not returned, interest may dramatically reduce the death benefit, putting the policy at danger of not paying out any money to beneficiaries.

If the loan is not repaid before the insured person dies, the insurance company will lower the face value of the insurance policy by the amount still due when the death benefit is awarded.

If you repay all or a part of the loan, you have the choice of making periodic principle payments with yearly interest payments, paying annual interest simply, or deducting interest from the cash value. It is prudent to make at least interest payments so that the insurance debt does not expand.

In the worst-case situation, if the loan amount exceeds the cash value of your insurance, your life insurance policy may expire and be cancelled by the insurance company. In such a circumstance, the IRS considers the policy loan amount plus interest to be taxable income, and the bill might be substantial.

  Triple-Tax-Free Definition

Is a life insurance policy loan taxable?

Not at all. Be wary, though, since this changes if you surrender your insurance or the policy expires, and the amount owing exceeds the amount put in. The loan then becomes a taxable event.

What happens to the death benefit if a policy loan isn’t repaid?

If the loan is not returned before the insured person’s death, the insurance company will lower the face value of the insurance policy when the death benefit is paid by the amount still due. In other words, if you own the insurance, your beneficiaries will get less after you die. So repay those debts.

What is a worst-case scenario with respect to policy loans and taxes?

If the loan amount exceeds the cash value of your insurance, your life insurance coverage may expire and be cancelled by the insurance provider. In such a circumstance, the IRS considers the policy loan amount plus interest to be taxable income, and the bill might be substantial.

This article does not provide tax or legal advice and should not be used in place of such guidance. State and federal laws are constantly changing, and the information in this page may not represent your state’s laws or the most current revisions to the law. Please contact an accountant or an attorney for current tax or legal advice.

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