Accessing Cash Value: Loans, Withdrawals, or both?
Many people have been sold cash-value life insurance with the off-the-cuff comment by the agent that “you can take loans on your cash value tax-free and never have to pay them back.” That statement is essentially true, but is it a good idea to do so?
To make an educated decision, you need to know the definition, benefits, and potential contract and tax consequences of the two ways of using cash values: loans and withdrawals.
There are two accounting measures of a policy’s cash value: the account value and the surrender value. The latter is a net amount of cash value available to the policy owner should s/he “cash in” the policy. The surrender value is basically the account value minus any surrender fees (“back-end” charges) that the carrier used to set up the policy in the first place.
A loan does not technically reduce the “account value” of the cash in a policy. However, it does reduce the “surrender value” and “death benefit” dollar-for-dollar. The current credited interest rate continues to be paid on the “account value” – including the loaned-out amount – except with the very few carriers that still practice “direct recognition”*
Sometimes the credited interest rate equals the interest rate of the loan, creating a “zero-cost loan”. That is a real financial advantage to the policy owner. However, zero-cost loans are becoming less likely to occur since the credited interest rates and credited dividend rates paid to cash values have been declining for years, but the interest rates credited to loans have not (At application time, an applicant can usually choose a “fixed” loan rate or a “variable” loan rate, with “variable” probably being the best choice today. However, if interest rates go up….).
While you don’t have to pay it back, unpaid loan interest and unpaid loan principal could result in a policy lapsing with no value at some point in the future. And, to rub salt into that wound, if the unpaid loan + unpaid interest exceeds the total amount of premium paid into the policy the carrier may send a 1099 to the IRS reporting that figure as a “policy gain” and treated as income for tax year in which the policy lapses1.
A withdrawal is a partial surrender of cash values. This results in a reduction of the “account value” of the policy and a permanent reduction in the death benefit. Withdrawals in excess of basis can be subject to income tax in the year that they are taken. It is important to remember that any interest or dividends paid by the carrier are credited to the account value of the policy. So by taking a partial withdrawal, clients are lowering the account value, lowering the potential interest that could be earned, and reducing coverage. Note that each carrier may have their own definition of what a withdrawal is and how it affects the policy values.
Withdrawals to basis, then loans This used to be a common way to illustrate a maximum use of cash values later in life when the need for insurance coverage would have theoretically diminished. The policy owner takes withdrawals to the point at which taking any more would create a tax event, then changes to taking loans against the cash values until it gets to a point that loaning out any more could lapse the contract. Lapsing the contract could create a serious tax event, so following this strategy has to be monitored carefully by a professional tax advisor and almost always requires continuous payment of premium to be successful. The reason that this strategy is not as advantageous as it used to be is due to an interest rate market that is at its lowest point in decades. Without sufficient interest being credited to the account value, less money can safely withdrawn and/or loaned out.
Bottom line Loans, withdrawals, or a combination of the two, are not without some risk in these times, and should not be counted on or used without comprehensive financial planning, ideally, by an insurance professional. Policy owner services at the back office of the insurance company that issued the policy can also be of great help.
NOTE ON CASH VALUES: Cash values result in a permanent plan of insurance when level premiums are illustrated to create a lump sum of income-tax free money (death benefit) that will pay out no matter when the insured dies. The policy owner “over-pays” the actual costs of insurance in the early years of the policy to produce a cash reserve that will support the death benefit until the person dies. That cash reserve or cash value can be accessed by the policy owner. Level premium is calculated on the assumption of a credited interest rate or a credited dividend rate that will remain constant over the life of the policy, which will NOT happen.
Insurance companies provide two credited interest rates on universal life plans of insurance: a guaranteed credited interest rate and a current credited interest rate. If a UL policy’s initially calculated premium is based on current costs of insurance and the guaranteed credited interest rate, the carrier guarantees that the policy will not lapse – regardless of cash value – as long as the required premium is paid in full and on time. If the initial premium calculated is based on current costs of insurance and current credited interest rates, a greater amount of premium may be needed in the future if the credited interest rate declines.
Whole life policies pay “dividends”, which are primarily a return of premium and are not taxed unless taken as a cash payout. Dividends are typically added to cash value and my also increase the death benefit. dividends are not guaranteed, but there are contractually guaranteed cash values and death benefit that do not rely on fluctuating costs of insurance or interest rates.
*Direct recognition means that the carrier “directly recognizes” those policy owners that do not take loans. Those that do take loans against their cash value get a lower credited interest rate on the borrowed amount. As the loan is paid back, the “account value” is increased by the payments and earn the current credited interest rate. This policy is a remnant of the inflationary days of the late 70s and 80s when people were moving money out of cash-value life insurance and into money-market bank accounts that were paying interest in double-digit amounts. This strategy is technically known as “disintermediation”. It is not likely that anyone would do such a thing in today’s interest environment, but the direct recognition continues with a few carriers today, primarily mutuals. If you’re counting on taking money from your policy later, it would be a good idea to know if the carrier you are planning to buy from practices direct recognition.
1. “Basis” is insurance-speak for “the total amount of premium paid into a policy to-date”. If gains, payouts, or loans exceed “basis”, there may be income-tax consequences in the year of any of those kinds of distributions from a life insurance policy. Consult with a qualified tax advisor for all tax matters.
