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Making Policy Loans and Withdrawals

February 19, 2019

John Jastremski Presents:

 

Making Policy Loans and Withdrawals

 

Cash value life insurance refers to a wide variety of insurance policies that provide both a death benefit and a cash value component that may build tax deferred over time. Many cash value policies let you borrow or withdraw from the cash value. This can sometimes be a good way to raise funds for expenses or emergencies. However, before you take a loan or withdrawal from your policy, make sure you explore all of your options and understand the issues involved.
Give me an L-O-A-N

You may be able to borrow against the cash value in your life insurance policy. Unlike obtaining a bank loan, policy loans don’t require a credit check or bank approval. That’s because the cash value that has built up in the policy is the collateral for your loan. Another advantage is that the interest rate on the loan may be determined in advance and may be lower than rates offered by banks. The interest on policy loans may also be tax deductible if the policy is owned by a business.

If you take out a loan against the cash value of your insurance policy, the amount you borrow is not taxable income to you, except in the case of a modified endowment contract (MEC). This is the case even if the loan is larger than the amount of the premiums you have paid. But keep in mind that the policy must remain in force for the loan to maintain its tax-free status. If the policy is surrendered or lapses, the loan is considered a distribution from the policy and may be taxable income to you.

So what are the drawbacks? First of all, interest accrues on the unpaid loan balance (though in some cases, part of the interest paid may be credited back to your cash value). If you choose not to repay the loan, the accruing interest could erode your cash value and eventually result in a policy lapse. There also may be an opportunity cost with policy loans, because the amount you borrow may miss out on tax-deferred growth. Finally, if you die before the loan is fully paid off, the policy death benefit will be reduced by the outstanding loan and interest balance. That could jeopardize your beneficiary’s financial security.
Making withdrawals–take it out and keep it out

You may be able to withdraw some of the cash value from your life insurance policy. However, the amount you can withdraw is generally limited to a percentage of the cash value and varies by policy and company. As long as you maintain enough cash value in the policy, you can withdraw the cash from the policy and still keep the life insurance in effect to provide a death benefit for your family and loved ones. Also, unlike a loan, a withdrawal doesn’t have to be paid back.

When you begin to withdraw from an eligible cash value life insurance policy, the amount of withdrawals up to your basis in the policy will be tax free. Your basis is the amount of premiums you have paid into the policy minus any previously paid dividends or tax-free withdrawals. Any withdrawals in excess of your basis will be taxed as ordinary income.

The main disadvantage of cash value withdrawals is that such withdrawals will lower your death benefit, possibly putting your beneficiary at risk. And, as with a loan, there’s an opportunity cost when you take money out of a tax-deferred account.
A dash of loan with a pinch of withdrawal

Cash value withdrawals and policy loans are not mutually exclusive events. You can use a combination of withdrawals and loans to maximize the tax-free benefits. You might choose to make a cash value withdrawal up to the amount of your policy basis and then take a policy loan. This strategy can give you the money you need while keeping taxes and interest payments to a minimum.
A crash course in modified endowment contracts

Before the MEC rules were passed, it was possible to place large amounts of cash into a single premium life insurance policy where a large portion could grow tax deferred, and at the death of the insured, the proceeds passed tax free to the beneficiary. If the money was needed, the policyowner could access the cash value through tax-free lifetime loans or withdrawals. These policies were being used in place of other investment vehicles, the earnings on which were subject to income tax.

However, the law relating to withdrawals from life insurance policies changed in 1988. Since then, if the total premiums paid during the first seven years of the policy exceed a maximum amount set by the IRS (called the 7-pay test), then the policy becomes a modified endowment contract, or a MEC. A MEC isn’t treated any differently than a non-MEC life insurance policy regarding tax-free death benefits and tax-deferred cash accumulation. But pre-death withdrawals from the cash accumulations of a MEC are taxed differently. Any withdrawals (including loans and partial surrenders) taken from cash accumulations are taxed as ordinary income to the extent there is gain in the policy. A tax penalty of 10% on the amount withdrawn from the MEC also may have to be paid if the policy owner is under the age of 59½, unless an exception applies.

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of John Jastremski, Jeremy Keating, Erik J Larsen, Frank Esposito, Patrick Ray, Robert Welsch, Michael Reese, Brent Wolf, Andy Starostecki and The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com,  access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that specializes in transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.

John Jastremski is a Representative with FSC Securities and may be reached at www.theretirementgroup.com.

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