Insurance Loans for Retirees
Borrowing on Policy Avoids Current Taxes but Invites Later Issues
Senior citizens need to study the consequences of withdrawing cash from retirement funds and/or borrowing money against the cash value in their life insurance policies.
Retirees who need extra money for emergencies or travel often have the choice of withdrawing cash from their retirement account or borrowing against the equity in their life insurance policy. Both can have serious consequences, so they need to be studied carefully.
Withdrawing extra cash from your retirement account raises two issues:
- The withdrawal is usually taxable in the current year, which might come as a shock the following April 15.
- Taking money from an IRA decreases the annual earnings and may lessen the retiree’s monthly income from that source.
Repayment of Insurance Loan Can Be Delayed for YearsA loan on the insurance policy may have three attractions:
- It is not taxable as long as the policy is in force;
- The principal does not have to be repaid until the policy is dropped, canceled or the policyholder dies.
- The interest rate is usually an attractive fixed rate or a variable rate that the retiree previously agreed to. The interest must be paid annually, either in cash or with policy dividends.
However, the loan consequences can get much more complicated, depending upon the amount borrowed, the cash value in the policy, the dividends paid by the policy and the amount of the loan that is repaid each year.
Loan Balance Can Grow Faster than Cash Value
Normally the insurance company will not lend the policyholder more money than the current cash value of the policy. However, if the loan is not repaid, the principal and accumulated interest can grow faster and larger than the cash value of the policy. That can put the policyholder in a financial trap.
As Kathy Kristoff points out in the Los Angeles Times, the insurance company is not really lending the policyholder his own money, even if he has that much cash value in his policy. It is actually lending company money, using the cash value as collateral and holding the equity to keep the policy in force. That’s a benefit to the policyholder because he continues to collect dividends on the policy.
The seemingly small technical difference over what money is being loaned can make the loan a taxable transaction years after the loan is made.
Company Can Require Payment of Excess Over Cash Balance
If unwatched, the principal and interest can balloon to the point where the loan eventually exceeds the cash value. The insurance company will then send the policyholder an annual bill requiring him to pay the difference between the debt and the cash value.
If the policyholder does not pay that bill, the insurance company can cancel the policy. Once the policy is canceled, or the policyholder withdraws the cash value, the policy loses the tax exemption. That’s because Congress applied the tax exemption to insurance death benefits only.
When that exemption is lost, the dividends earned over the length of the policy may become taxable. Suddenly, the policyholder can be staring at a huge tax bill.
Several precautionary steps are suggested to avoid long -term tax problems:
- Before borrowing, consider the long-term consequences of both the pension withdrawal and the insurance loan. Research other loan possibilities.
- If possible, repay the insurance loan, or at least the annual interest on the principal.
- If the loan is not repaid, advise the insurance company to use the policy dividends to pay the annual interest.
- Monitor the growth of the principal and accumulated interest on the loan to make sure they do not exceed the cash value and that the annual interest does not exceed the annual policy dividends.
Sources:
Money Instructor.com
Los Angeles Times.com
Investor Guide.com
