Cash Value Loans on Insurance Policies

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One of the key selling points of life insurance, particularly whole life or cash value life insurance, is the ability to take withdrawals from the policy by taking loans against the policy and thereby not pay taxes.

The challenge that we face is that this same strategy can result in a tax bomb in the later years of your life. I’m going to explain how this apparently attractive feature can become your worst tax nightmare. 

Let me draw this on the board, because there’s no way I can explain it without a picture. I’m going to draw a picture here of what happens with the cash buildup in a permanent life insurance policy. We’re going to say for this example that you’ve invested $100,000 in a policy. Your cash value is $100,000, and let’s say it’s got a 4% guarantee. We’re going to call this the starting cash value. You need in retirement to be able to withdraw this money. Now in reality, you tend to withdraw money over time, but for this scenario, just to explain the math, we’re going to withdraw $60,000 from the underlying cash value in the form of a loan.

In summary, we have a starting cash value of $100,000 compounding at 4% and a loan of $60,000 at 6%. Let’s see how this works out over time. Taking the loan leaves $40,000 in remaining equity in the policy. Your cash value, compounding out at 4%, is going to grow over time and look something like that. Very familiar curve. Your loan value is also going to compound, but at a higher rate. There’s a crossover right about here. At this point, you have no equity in your insurance policy.

There’s a rule that states that when the loan value equals the cash value, the policy lapses and is no longer in force. You will receive a 1099. You no longer have your tax deferral. You have a taxable event. Fortunately, this isn’t going to happen right here – using our numbers it’s about nine years down the road – because the growth in the cash value is now greater than the cash value we started with. It’s going to get put down the road another 18 years to this point in time. The challenge is, 18 years down the road you’re pretty deeply into retirement, and this is the worst possible time for you to, one, run out of cash value, and two, simultaneously get hit with a huge tax bill.

How does that happen? This area right here is called phantom income. It’s phantom, of course, until the policy lapses, and then in the eyes of the IRS it becomes very real income. How much? If you do the math, this should be about $288,000. We started with a cash value of $100,000. If this were cash, you would have $188,000 of ordinary income the minute this policy lapses. If it’s a qualified account, if you had rolled over an IRA into this type of product, you would actually have the full $288,000 in ordinary income – taxable income.

What does that mean? At the 25% tax bracket, you’re looking at $47,000 in tax or $72,000 in tax. I ask you … you’re in your early 80s, you’re in retirement, your policy no longer has any cash value, there is no longer a death benefit because it’s lapsed, and you’re hit with a $72,000 tax bill. That probably was not what you had in mind when you put the funds into this kind of an investment.

Conceptually, where did we go wrong with this investment? The first thing is, you have to understand: you’re not borrowing your money; you’re borrowing from the insurance company. Now the insurance company is collateralizing the debt with your money, so it’s a no-lose deal for the insurance company, but you are not borrowing your own money. That is why when this debt comes due and it is no longer collateralized, by law, this policy lapses.

Is there a better way where you could’ve reached the same objective without incurring this probability of risk? The challenge when you put together a portfolio is to not outlive your resources. This actually increases the chance of portfolio failure over time. This is the exact opposite of what you want to do. How do you do the opposite, have access to this kind of money but decrease the probability of portfolio failure? There are three ways to do it, and I’m going to briefly tell you what they are.

First, you could go out, take your $100,000, and pay off your mortgage. Then, once you hit 65 and you’re eligible, you can go ahead and get yourself a reverse mortgage. With a reverse mortgage, you’re in essence doing the same thing. You are borrowing money against collateral. The difference is there’s no lapse process. The only way you lapse on a reverse mortgage is by dying. Most people when they’re dead don’t care so much about their balance. They knew this agreement when they went into the reverse mortgage process.

The second way you could do this is to get what’s called a deferred income annuity. This is one of the very few annuities that we as fiduciaries recommend, and even if we recommend it we would outsource the service because we don’t take commissions. A deferred income annuity does the exact opposite [of a policy loan]. Though it generates income for the rest of your life, and though there is a modest tax footprint to that income – it’s not invisible but very modest – it does the exact opposite in that it increases the probability of success, because that deferred income annuity pays out for the rest of your life.

Then there’s the third way, and the third way is to have a tax-efficient portfolio. Though a tax-efficient portfolio, rebalanced and managed over time, is not tax exempt, it is only subject to capital gains taxes to the extent that you realize them on purpose. If you manage that portfolio in a tax-efficient manner, if you take losses against gains, use tax-efficient dividends, you’ll get a tax footprint, but it’ll be a very light touch. At the end of the plan, assuming there are resources remaining, that account will get a step up in basis, so it’s really very tax efficient.

Those are three ways to do what you’re trying to do with this insurance. The biggest problem with the insurance, other than the tax bomb at the end, is the cost of the product. Inefficient underlying funds is very typical. You’ve got the insurance charges. You’ve got commissions built in. This product is expensive. These are three inexpensive ways to solve the same problem.

I hope this is of value, and I wish you the best of investing success. Thank you.