Policy loans are central to many sales pitches for cash value life insurance. The idea is simple: borrow from your policy instead of withdrawing, and avoid income tax. The reality is more nuanced. Loans can be useful, but only if you understand the conditions and the risks.
How a policy loan works
When your permanent policy has built up cash value, the insurer may let you borrow against it. You are not usually withdrawing your own money. Instead, the insurer lends you money, using your cash value as collateral. Key features:
- No credit check is typically required.
- There is generally no fixed repayment schedule.
- Interest accrues on the loan at a rate set by the policy.
- Part of your cash value may continue to earn credits, but the amount securing the loan may earn differently depending on the policy design.
Why loans are generally not taxed as income
Because it is technically a loan and not a distribution, the proceeds are generally not treated as taxable income at the time you receive them, provided the policy remains in force and is not a modified endowment contract. That is the basis for the "tax-free retirement income" pitch. But the conditions matter.
What can trigger taxes
- The policy lapses with a loan outstanding. If the policy ends and there are loans larger than your basis in the contract, the excess can become taxable income, often without any cash in hand to pay the tax.
- The policy is a modified endowment contract (MEC). If you fund a policy faster than tax-law limits allow, it is classified as a MEC. Loans and withdrawals from a MEC are generally taxed on a gains-first basis and may face an additional 10 percent tax before age 59½.
- You surrender the policy with loans outstanding and gain in the contract.
Other costs and trade-offs
- Interest. Loan interest can be fixed or variable and often compounds against you.
- Reduced death benefit. Unpaid loans are subtracted from the death benefit paid to beneficiaries.
- Complex interactions. Some policies have loan features that credit differently on borrowed amounts, so the net cost depends on the design.
- Impact on guarantees. A heavily loaded policy may require more premium to stay in force.
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Request my Retirement Income ReviewLoan vs. withdrawal
A withdrawal permanently reduces cash value and may reduce the death benefit. Withdrawals up to basis are generally tax-free in non-MEC policies, while amounts above basis are taxable. A loan leaves the cash value in place as collateral but creates a debt. The better choice depends on your policy and plan, which is why you should ask the insurer to model both.
How to use loans carefully
- Ask for an in-force illustration showing the effect of the loan at your age under conservative assumptions.
- Keep the policy well funded so it can support loans.
- Avoid taking loans that approach the full cash value.
- Monitor annually. Review statements for loan balance, interest, and lapse risk.
- Know your options if the policy weakens, such as repaying part of the loan or adding premium.
- Talk to a tax professional before taking large loans.
Alternatives to consider
Depending on your goals, alternatives may include drawing from taxable or retirement accounts in a planned order, a home equity line, or a fixed annuity income stream. Compare after-tax cost and risk. See also is cash value life insurance a good retirement supplement.
A simple illustration with made-up numbers
Suppose someone has a policy with a cash value of a certain amount and borrows a portion each year to supplement retirement income. Each loan accrues interest, so the debt grows even when no new money is borrowed. If the debt eventually approaches the cash value, the policy may need extra premium to stay in force. If it lapses, the outstanding loan can be treated as a distribution, which may create taxable income. These numbers are hypothetical, but they show why monitoring matters as much as the original plan.
Keep documentation
Keep copies of your loan agreements, annual statements, and any illustrations you were shown. If you later need to explain the transactions to a tax preparer, those records make the work much easier and reduce the chance of mistakes on a return.
How we help
Honorbrook is an independent agency. We explain how policy loans work for the policies we offer and encourage you to review projections with your tax advisor. We do not provide tax advice.
Availability and rules vary by state
Life insurance and annuity products, rates, riders and consumer protections differ by state, and a given product may not be available in every state. Honorbrook is licensed in the 11 states below; which products we can offer you depends on what carriers sell in your state. Each state’s insurance regulator can verify an agent’s license and answer consumer questions.
- Virginia: Virginia Bureau of Insurance
- Maryland: Maryland Insurance Administration
- North Carolina: North Carolina Department of Insurance
- South Carolina: South Carolina Department of Insurance
- Georgia: Georgia Office of Insurance and Safety Fire Commissioner
- Alabama: Alabama Department of Insurance
- Louisiana: Louisiana Department of Insurance
- Texas: Texas Department of Insurance
- Michigan: Michigan Department of Insurance and Financial Services
- Indiana: Indiana Department of Insurance
- West Virginia: West Virginia Offices of the Insurance Commissioner
This article is general education, not tax, legal, investment or insurance advice. Indexed and cash value life insurance is not a direct market investment. Credited interest depends on the insurer’s caps, participation rates and spreads, which can change; policy charges, fees and surrender charges apply, loans and withdrawals can reduce the death benefit and may be taxable, and guarantees depend on the issuing insurer’s claims-paying ability. Suitability depends on your situation; consult a qualified tax professional before acting.