Insurance Loan Rescue: A Life Preserver for a Borrower in Over Their Head

Insurance Loan Rescue: A Life Preserver for a Borrower in Over Their Head

There are several types life insurance, but whole life insurance offers policy owners the boon of cash value accumulation as well as a death benefit.

With a whole life policy, value accumulates based on the insurance company’s dividend, which is debited to the policy owner’s account. As the value accumulates, the owner can use the cash value to pay premiums, withdraw some of the value, or take a loan against the cash value. As with any loan, the borrower must pay interest. If the borrower fails to pay back the loan, the amount due is deducted from the death benefit.

Traditionally, loans against insurance policies have been attractive given relatively favorable interest rates, as the insurance company can force the surrender of the policy and its cash value in the event the loan isn’t repaid. Today though, with interest rates at rock bottom levels, the 4-8% typically charged on loans against cash value is no longer so attractive. Policyholders can find much more attractive rates by borrowing elsewhere and may be looking for ways to refinance expensive loans.

When a borrower against a policy’s cash value fails to make loan, the interest accrues in the policy, eating away at the cash value. Ultimately, if the loan is not paid it will force the surrender of the policy. While this may get the borrower off the hook for the loan, it can create another problem. The surrender can be fully taxable as a gain, even if the policyholder receives no proceeds from the surrender. How can this frightening scenario transpire? Let’s look at an example.

Say that Fred is the holder of a whole life policy with a death benefit of $1 million and a cash value of $300k. He borrows $200k against the cash value, but shortly thereafter his business runs into trouble and he doesn’t make the payments. Interest continues to accrue, and the amount due rises to $290k. The policy lapses. Fred heaves a sigh of relief; his family may be up the proverbial without a paddle in the sad event of his death, but at least the debt is cleared.

Not so fast, Fred. Let’s say Fred has paid $150k in premiums on the policy. Uncle Sam considers that the basis – any value over that figure is taxable as ordinary income. Fred’s going owe income tax on the difference between the $290k loan value and the basis. That’s $140k that Fred will own income tax on, and the liability could be sizeable.

Policyholders who find themselves in the soup are naturally keen to avoid Fred’s unfortunate rendezvous with the taxman, and most are loath to leave the families unprotected. Fortunately, sharp minds in the industry have developed some “rescue” strategies for life insurance policies with onerous loans, and these strategies can help policyholders keep their policies in place and their families protected. The wizardry can include some combination of restructuring the dividends and death benefit, partial surrenders, or additional premium payments. But one of the most efficient rescues comes in the form of a tax-free 1035 exchange that transfers the policy’s cash value, along with the loan, into a new, more efficient policy with better terms.

The 1035 replacement is the best option for a policyowner who is unwilling or unable to put additional cash into an existing policy. In some cases, the replacement can be particularly attractive – for example, the policyholder has lost 100 pounds and stopped smoking – the premiums on the new policy could be lower. Other factors can also result in a lower premium; a poor choice might have been made initially, or the risk profile according to actuarial figures and life expectancy projections. The replacement policy may offer more flexibility (for example, a universal life policy rather than a whole life policy) or simply be less expensive.

The new policy may also have more attractive loan terms, such as more favorable interest rates. For example, the rate could be the prevailing interest rate plus a spread of 50-100 bps., which could be significantly lower than the rate on a policy issued twenty or more years ago.

It’s crucial to note, though, that when the 1035 exchange is made, the new policy must assume the same loan value as the old policy. Otherwise, if a policy with a loan is exchanged for a policy without one, Uncle Sam will consider the transaction a partial liquidation and his bony hand will be in the policyholder’s pocket to collect the income tax due.

While the rescue strategy offers an excellent route out of trouble, it’s still necessary to choose the replacement policy carefully. One important concern is how the cash value will be invested and whether the interest rate paid is reasonable. If the rate turns out to be less than anticipated, as could be the case with an indexed universal life policy, the policyholder could end up in trouble again.

Whether a borrower is having trouble making payments or wants a better interest rate on an existing loan, the 1035 replacement can be an attractive solution, keeping families protected and fending off the predations of the rapacious taxman.


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