How to borrow from your whole life insurance policy

FAQs in this article ...  How can whole life insurance, beyond providing protection, be used as a financial resource? How do policy loans work and what are the risks involved? What are the tax implications, both positive and negative, of policy loans?

A whole life insurance policy is first and foremost about protection. But, if a sudden need arises, it may be able to offer something more than just a death benefit for your loved ones: it can provide you with a loan.

However, before you tap into this resource, it's crucial to understand that taking a loan from your life insurance policy can have significant negative effects, including reduced death benefits, increased lapse risk, and potential tax consequences.

Nevertheless, there may be times when taking a loan from your life insurance policy may make sense. But you need to know how policy loans work and what the tax implications are. Indeed, even with this basic understanding, many opt to discuss their options with a financial professional to fully understand their situation.

Understanding whole life insurance cash value

Whole life insurance is a type of permanent life insurance that provides lifelong coverage while building a cash value component. As you pay your premiums, a portion goes toward this cash value, which grows on a tax-deferred basis at a rate guaranteed by your insurance carrier.

Unlike market-based investments, the cash value in your whole life policy is not directly affected by market conditions, which may make it an appealing source of accessible funds.

“As an advisor, I always check to make sure clients leave enough cash inside the policy to keep it active so that they don’t lose coverage and possibly get stuck with a tax bill on something that should be a tax-free loan should the policy lapse,” noted Doug Collins, financial planning director at Fortis Lux Financial in New York City.

How to take a loan from your policy

The process of borrowing from your whole life insurance policy is relatively straightforward. Depending on the policy provisions and available cash value, you can typically access your cash value at any time and for any purpose — no credit check required. However, in the early policy years, cash value accumulation is generally limited, and there may be little or no cash value available for policy loans.

Here's what you need to know:

The loan request process:

• Contact your insurance company or financial professional to request a policy loan. (For MassMutual clients, you can contact MassMutual Customer Service or go through your online account.)
• You can typically borrow up to a certain percentage of your available cash value.
• The loan is issued quickly, often within days.
• There's no formal approval process or qualification requirements since you're borrowing against your own policy.

Key loan features:

• Interest rates on policy loans can be more favorable than personal loans or credit cards.¹
• You're not required to make regular payments or follow a specific repayment schedule.
• If you don't repay the loan during your lifetime, the outstanding balance plus interest is deducted from the death benefit paid to your beneficiaries.

The tax advantages of policy loans

One of the most attractive features of whole life insurance loans is their tax treatment. When structured properly, accessing your policy's cash value can provide significant tax advantages.

Tax-free access up to the cost basis: Generally, money borrowed or withdrawn from your life insurance policy is not subject to income taxes up to your "cost basis" — the total amount you've paid into the policy through premiums. This tax-advantaged access can make policy loans an appealing option for those seeking funds without triggering immediate tax consequences. (Learn more: How life insurance provides 3 distinct tax benefits)

Additional tax benefits:

• There's no penalty for accessing cash value before age 59½, unlike retirement accounts.
• Policy loan income (up to the cost basis) is not included in calculations for taxes on Social Security benefits.
• The tax-deferred growth of your cash value continues even with an outstanding loan.

Understanding the tax consequences and risks

While policy loans offer tax advantages, they also carry risks that could result in unexpected tax bills.

So, you need to understand these potential consequences before borrowing.

The danger of policy lapses: The most significant tax risk comes if your policy lapses — meaning it terminates due to insufficient cash value to cover premiums and loan interest. If your policy lapses with an outstanding loan exceeding your cost basis, the excess becomes taxable income.

Here's a hypothetical example:

• You've paid $50,000 in premiums on your whole life policy (the cost basis).
• You took a $75,000 loan but let the policy lapse.
• You would owe taxes on $25,000 of income.

The modified endowment contract exception: If your policy has been classified as a modified endowment contract, or MEC, different tax rules apply. With a MEC, policy loans and distributions are taxable to the extent of any gains, and if you're under age 59½, you'll also face a 10 percent early withdrawal penalty.

Impact on death benefits: Every dollar you borrow reduces both your cash value and the death benefit your beneficiaries will receive. Any outstanding indebtedness on the policy at the time of the insured’s death will be deducted from the amount paid to the beneficiaries. If you don't repay the loan, your loved ones receive less financial protection — potentially undermining the primary purpose of your life insurance policy.

When policy loans may make sense

Despite the risks, policy loans can be appropriate in certain situations. These could include:

• Emergency expenses when you need funds quickly and want to avoid credit checks.
• College tuition payments as an alternative to higher-interest student loans.
• Supplementing retirement income during market downturns, allowing market-based investments time to recover.
• Short-term cash flow needs when you have a plan to repay the loan.

Whether a loan is appropriate for you depends on your policy provisions and alternatives. The key is having a clear repayment strategy and understanding how the loan fits into your overall financial plan. Consider discussing your options with a financial professional.

“When evaluating the rate of return on cash values, what makes it attractive is that it is generally a tax-free rate,” said Collins. “However, if the policy is mismanaged and results in a tax on gains, the rate of return is not competitive to other savings vehicles when strictly focusing on the cash component of life insurance.”

Protecting your policy and your beneficiaries

If you decide to take a policy loan, take these steps to minimize negative impacts:

1. Maintain premium payments to prevent your policy from lapsing.
2. Monitor your loan balance and interest charges regularly.
3. Set a repayment plan and consider making interest payments to prevent the loan from growing.
4. Review beneficiary protection to ensure that adequate death benefit coverage remains.
5. Consult a financial professional to understand your specific policy terms and tax situation.

Conclusion

Borrowing from your whole life insurance policy can provide valuable financial flexibility, but it's not a decision to make lightly. The tax advantages are real — access is generally income-tax-free up to your cost basis and continued tax-deferred growth — but so are the risks of reduced death benefits and potential tax consequences if your policy lapses with a outstanding loan.

Before taking a policy loan, carefully evaluate your financial situation, repayment ability, and the impact on your beneficiaries. Understanding how policy loans work and their potential consequences will help you make an informed decision that supports both your current needs and long-term financial goals.

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Whole life insurance: Balancing protection and accumulation

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