Given this dynamic, if Andrew were to pass away, the policy would pay a net death benefit of $600,000, based on the $1,000,000 life insurance death benefit reduced by the $400,000 loan balance
Since receiving the proceeds of a personal loan are not taxable, it is perhaps not surprising that the repayment of that loan isn’t taxable either. Repaying the principal of a mortgage doesn’t have tax consequences, repaying the balance on a credit card doesn’t have tax consequences, and repaying a personal loan for which a life insurance policy is collateral doesn’t trigger any tax consequences either.
However, the “no tax consequences” outcome of repaying a life insurance policy loan can be impacted by how the loan is repaid. To the extent that it is repaid with ‘outside’ dollars (unrelated to the life insurance policy itself), the repayment is not taxable just as the receipt of the loan proceeds weren’t taxable either. On the other hand, if the repayment of the loan involves drawing money from the life insurance policy itself, the outcome may be different.
Repaying Life Insurance Loans On Policies Held Until Death
If a life insurance policy with a loan is held until death, the insurance company ultimately uses the death benefit proceeds of the life insurance policy to repay the loan, with the remainder paid to the policy’s beneficiary.
In point of fact, this is why any form of life insurance policy loan is shown as a ‘reduction’ to the death benefit of the policy. Because the life insurance company uses a combination of the policy cash value (while alive) or the policy death benefit (after death of the insured) to provide collateral and ‘guaranteed’ repayment of the loan. In other words, technically when a life insurance policy loan occurs, the death benefit is not actually reduced (which means the cost-of-insurance charges don’t ount-at-risk to the insurance company); instead, the insurance company simply recognizes that any final death benefit to be paid will be reduced first by the repayment of the loan balance.
Example 2. Andrew has a $1,000,000 whole life insurance policy that, by the time he has now turned 65, has almost $200,000 of cash value, and since he has only put in about $140,000 in premiums over the years, he faces a potential $60,000 gain if he surrenders the policy to use the cash value as a retirement asset. To tap the policy’s cash value, and free up available cash flow, Andrew decides to stop paying the $5,000/year premium on the policy, and take out $15,000/year in the form of a policy loan. (Notably, the total annual policy loan would be $20,000/year, as with a whole life policy the premiums are required to be paid, and so “not paying premiums” simply means the insurance company will automatically take out a loan every year and use the proceeds to pay the annual premium obligation.)
By the time Andrew turns 80, his cash value will have risen to nearly $450,000, through a combination of ongoing growth and the ongoing contribution of premiums (paid via the personal loans from the life insurance company). The loan balance itself will be up to $400,000, with loans of $20,000/year (in total) plus accrued interest.
Notably, though, even though the net death benefit is only $600,000, Andrew’s life insurance policy still has cost-of-insurance charges calculated based on the original death benefit, not just the reduced death benefit amount.
From the tax perspective, though, the repayment of a life insurance policy loan from the death benefit of the policy is tax-free, because the payment of a death benefit itself (by reason of the death of the insured) is tax-free in the first place. In other words, to the extent that a life insurance loan is simply a online Nashville payday loans personal loan with the insurance company that is repaid from the death benefit proceeds, the policy loan repayment is as “not taxable” as any loan repayment is, and the tax-free life insurance death benefit remains tax free.