Borrow from a whole life insurance policy
If you purchase whole life insurance and have a bank account hit hard by the coronavirus pandemic, you might consider borrowing against your policy. However, use your insurance the wrong way and you could create as many financial problems as you solve.
Unlike a term life insurance policy, which has no value other than what it pays on death, whole life insurance has a cash value that is independent of the death benefit. You can borrow against this value as needed, as I did when I bought my own policy for $ 500 decades ago. Given when I was a child by my mother’s father, and with a modest death benefit, the plan was to make sure I always had insurance and to give myself an asset I could borrow against if needed.
Taking a loan from a whole life insurance policy could get you the money you urgently need at a great interest rate. However, if you mismanage the loan, you can sabotage the reasons you bought the policy, lose the policy, or create an income tax bill you can’t afford to pay.
Here’s a look at how to plunder a whole life insurance policy, along with tips on the wisdom of doing so versus other potential options.
How whole life insurance works
Unlike term coverage, which protects for a specified period (twenty years is typical), whole life insurance remains in effect for as long as the policy is funded.
At the start of the policy and for a few years, you fund the policy by paying annual level premiums. Over time, with many policies, you receive dividends based on the financial performance of the insurance company, which you can use to offset premiums. The cash value also accumulates in your policy and you can borrow against that cash value.
The case of a loan
Borrowing against the cash value of a policy is good business in several ways. First, the insurance company cannot refuse your loan application. If there is money to borrow in your policy, it’s up to you to borrow, regardless of your current income or credit history. “They can’t deny you a loan unless you’ve already borrowed all of the cash value,” says Michael Whitman, a financial planner based in Chapel Hill, North Carolina.
If you press the policy, the insurance company will likely charge you a favorable interest rate. “The best whole life insurance policies have a low interest rate for loans against cash value,” says Michelle gessner, a financial advisor in Houston, Texas. “A lot of good life insurance policies charge less than 5% interest. Some policies have a zero cost loan if you have held the policy for ten years or more.
The interest rate you pay to borrow is specified in the policy. Plus, says Whitman, “the company might even pay interest on the cash value of your policy.” In other words, you will essentially be reimbursed, albeit indirectly, for the cost of the loan.
Once you take out the loan, there is no specific repayment schedule. You pay it back if and when you want. It sounds like a useful feature, and it can be. Yet, this can also turn into a substantial inconvenience.
Pay off the principal or reduce your policy benefits
No one will sue you or insist that you pay off your policy loan. But if you don’t, you could end up with at least one nasty surprise.
On the one hand, you might capsize the reason you bought the policy in the first place. “Whole life insurance policies can grow tax free, so people use them as retirement supplements,” Gessner explains. “If you take out a loan when you’re already retired, you don’t have to pay it back. The loan meets your goal of providing retirement income. “But if you’re not retired or near retirement,” Gessner adds, “you’ll want to pay it back.” Otherwise, the money will not be there to serve its original purpose.
People also buy whole life insurance policies because their families plan to use the death benefit to take care of loved ones or pay estate taxes. You will want to repay the loan in full if your heirs need the death benefit. If you die before full repayment, the outstanding balance will be deducted from your death benefit, just like any other loan.
Ignoring interest can cause politics to fail
No one is going to charge you the interest on your loan either, and that could become an even bigger problem. “Say you borrow $ 10,000 from your contract at 5% interest,” says Whitman. “Each year that 5% must be repaid, or the interest will be added to the loan and capitalized.” If you don’t pay interest, you’ll owe $ 10,500 at the end of the first year and $ 11,025 at the end of the second.
The insurance company will credit your dividend against your annual premium, interest and principal. If the loan is small enough, the dividend could even pay it off. This is what happened with the $ 500 loan I took out against my policy.
For a larger loan, however, the dividend ultimately won’t match the power of compound interest. Dividend payments will not be enough to keep the policy afloat. If you are unable to contribute to the policy, the company will cancel it.
The taxman could come
As if canceling the policy for non-payment was not enough, you will also owe income tax on the difference between what you paid into the policy and the loan and the interest you took out. “It’s a trap for the unwary,” says New York-based financial adviser David Mendels. “The insurance company is happy to allow you to treat each unpaid interest payment as a new loan. There is no tax payable until you decide or are forced to cancel the policy.
At this point, all of those interest payments and the loan principal, less any premiums paid, become taxable as ordinary income. “It’s hard enough to pay taxes on the income you receive,” Mendels says. “It’s really hard to pay taxes on money you haven’t received. “
You can take out a loan and let the policy voluntarily expire, as long as you allow for the tax bill. That’s what Peter Lazaroff, a financial planner in St. Louis, Missouri, did when he bought his first home. He borrowed $ 30,000 on a whole life insurance policy his parents bought when he was a baby. Three years later, the policy lapsed, and Lazaroff paid taxes on approximately $ 15,000 – the difference between the premiums paid on the policy and the principal and interest on Lazaroff’s loan.
If you take out a loan because you are short of funds, it will likely be difficult for you to pay additional income tax. But if you know you can pay or offset taxes – by taking a loss on a different investment, for example – this strategy might work. Call your insurance company and ask for an effective illustration to find out how much you can borrow and how long your dividend payments can keep the loan and policy afloat.
Overall, however, you should probably approach borrowing against a whole life policy with caution. “I wouldn’t rule it out, but it wouldn’t be my first choice,” says financial adviser Mendels. “Better choices might include a zero percent credit card offer, a home equity line of credit, or an emergency fund. Tapping into retirement funds, he says, is a worse choice.