If you take out a loan against your life insurance policy, you generally won't have to pay income taxes as long as the policy remains in force.
However, you could potentially face a tax bill if you surrender your policy or if the policy lapses, and the amount you owe exceeds what you paid in. Essentially, in that case, you would have to pay income tax on any earning from the investment.
If a policy loan is outstanding when the policyholder dies, the beneficiary would receive a lower death benefit as a result, but that benefit would likely not be taxed.
- A life insurance policy loan isn't taxable as income, as long as it doesn't exceed the amount paid in premiums for the policy and the policy remains in effect.
- If you surrender your policy or your policy lapses, you must pay taxes on the money that came from interest or investment gains, even if you have an outstanding loan.
- Repaying a loan from your life insurance cash value isn't mandatory, but outstanding debt will be deducted from the death benefit.
How Much of a Life Insurance Loan Is Taxable?
You can take out a loan on a permanent insurance policy, like a whole or universal policy, that has a cash value. The money you borrow isn't taxable, as long as it's equal to or less than the sum of the insurance premiums you have paid.
But keep in mind that life insurance companies add interest to the loan. If you don't repay the interest charges, your policy could lapse.
A taxable amount equals the amount of the gain realized, which is any amount you received from the cash value of your policy minus the net premium cost, or the total of premiums paid minus distributions received. It is essentially the gains on the investments.
Let's say, for example, you've paid $40,000 in premiums and the cash value of your policy is $55,000. That means that $15,000 ($55,000 - $40,000) would represent the investment gains and would be subject to taxation if you surrendered the policy and took the cash value.
If you had an outstanding loan on the policy of $20,000, you would receive a reduced cash value of $35,000 but you would owe tax on the $15,000 in investment gains.
These same rules apply to a policy that lapses with an outstanding loan.
Other Considerations for Life Insurance Loans
Getting a life insurance loan is usually fairly easy and straightforward. You don’t have to go through an approval process because you are borrowing against your own assets. You can use the funds in any way you wish. Finally, you don’t have a repayment schedule or repayment date. In fact, you don’t have to repay a life insurance loan back at all.
However, if the loan isn't paid back before the insured person's death, the insurance company will reduce the face amount of the insurance policy by what is still owed when the death benefit is paid.
If a policy loan isn’t repaid, and unpaid loan and its interest can significantly cut into the death benefit, which can put the policy at risk of not providing enough money to beneficiaries.
If you do pay back all or a portion of the loan, your repayment options include periodic payments of principal with annual payments of interest, paying annual interest only, or deducting interest from the cash value. Consider making the minimum interest payments so the policy loan doesn't grow.
In a worst-case scenario, if added interest increases the loan value beyond the cash value of your insurance, your life insurance policy could lapse and be terminated by the insurance company. In such a case, you would owe income taxes on the overall gain in investments in your policy, regardless of the amount of loan you have.
Is a Life Insurance Policy Loan Taxable?
A life insurance loan is typically not taxed. However, if you surrender your policy or the policy lapses, you will have to pay taxes on gains made through investments and your outstanding loan will be deducted from your payout.
What Happens to the Death Benefit if a Policy Loan Isn't Repaid?
If the loan isn't repaid before the insured person's death, the insurance company will reduce the face amount of the insurance policy by what is still owed when the death benefit is paid. In other words, the beneficiaries will receive less.
Do I Have to Pay Interest on a Life Insurance Loan?
You do have to pay interest on a life insurance loan. If added interest increases the loan value beyond the cash value of your insurance, your life insurance policy could lapse.
The Bottom Line
Being aware of how taxation applies to your life insurance policy can help you make the best decisions toward your financial goals. Consider consulting with a financial advisor for guidance on options that fit your unique situation.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.