Last week’s issue discussed those situations when borrowing on a life insurance policy could be considered appropriate; emergencies, opportunities, and disintermediation. This week the tax aspects of life insurance policy loans will be reviewed.
Generally, a policy loan will not create a taxable event, unless the policy being borrowed upon has been classified as a Modified Endowment Contract (MEC). In that case, the loan will be treated as ordinary income, but in the case where the policy is not a MEC, there will be no tax consequences to such a transaction.
This is true even when the loan exceeds the policy owner’s basis in the policy. Example: John has $100,000 cash value in his policy, with a basis of $75,000. If he takes a loan of $90,000, he will have a realized gain of $15,000, but he will not have to recognize the gain for income tax purposes. Of course, Congress could amend the tax code to change this situation.
However, if John were to then surrender the policy, he would have a taxable gain of $25,000; the $90,000 loan, plus the $10,000 of cash value he would receive upon surrender, less his basis of $25,000. The gain would identical were he to surrender the policy without first taking the loan ($100,000 cash value received, less his basis of $75,000 equals $25,000 gain, which would be taxed as ordinary income).
The same potential tax trap exists when a policy with an outstanding loan that exceeds basis lapses for non-payment of premium; the excess of the loan over basis is taxed as ordinary income. The same would hold true if the policy was transferred instead of lapsed.
So while the ability to borrow on a life insurance policy does have its advantages, care must be taken so as to not inadvertently create an adverse tax situation.
nota bene - This is general information presented for informational purposes only, and nothing in it should be construed as tax advice. Should you need information specific to your situation, you should speak with your tax advisor.