How Lapsing A Life Insurance Policy With A Loan Can Cause A Tax Bomb

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Executive Summary

Life insurance serves a valuable social purpose, allowing families to protect themselves against the economic consequences of an untimely death of a breadwinner. In fact, life insurance is viewed as such a positive that Congress provides significant tax preferences for insurance policies, including tax-deferral on any growth in the cash value, and a tax-free death benefit for the beneficiaries.

Another popular tax feature of life insurance is the ability to access the policy’s cash value in the form of a tax-free loan. However, in reality the tax-free treatment of a life insurance policy loan is not actually a preference for life insurance under the tax code, but the simple recognition that ultimately a policy loan is just a personal loan between the life insurance company and the policyowner, for which the life insurance cash value is collateral. A credit card cash advance isn’t taxable, nor is a cash-out mortgage refinance, and a personal loan from a life insurance company isn’t, either.

However, while a life insurance loan isn’t taxable – nor is its subsequent repayment – the presence of a life insurance loan can distort the outcome if/when a life insurance policy is surrendered or otherwise lapses. Because the insurance company will require that the loan be repaid from the proceeds of the policy.

In the case of a life insurance death benefit, this isn’t necessarily problematic. The death benefit is already tax-free, and the loan is simply repaid from the tax-free death benefit, with the remainder paid to heirs.

When a life insurance policy is surrendered or otherwise lapses, though, the remaining cash value is again used to repay the loan… even though the taxable gain is calculated ignoring the presence of the loan. Which means in the extreme, it’s possible that a life insurance policy can lapse without any remaining net cash value, due to a loan repayment, yet still produce a significant income tax liability based on the policy’s gains. This “tax bomb” occurs because in the end, even if all of a policy’s cash value is used to repay a life insurance loan, it doesn’t change the fact that if the policy had a taxable gain, the taxes are still due on the gain itself!

Author: Michael Kitces

Michael Kitces is Head of Planning Strategy at Buckingham Wealth Partners, a turnkey wealth management services provider supporting thousands of independent financial advisors.

In addition, he is a co-founder of the XY Planning Network, AdvicePay, fpPathfinder, and New Planner Recruiting, the former Practitioner Editor of the Journal of Financial Planning, the host of the Financial Advisor Success podcast, and the publisher of the popular financial planning industry blog Nerd’s Eye View through his website , dedicated to advancing knowledge in financial planning. In 2010, Michael was recognized with one of the FPA’s “Heart of Financial Planning” awards for his dedication and work in advancing the profession.

The Tax-Preferenced Treatment Of Life Insurance Policies

The biggest by far is the simple fact that a life insurance policy’s death benefit itself is entirely tax free. Under IRC Section 101(a), “gross income does not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured.” As a result, even if a policyowner never pays more than a single $1,000 premium for a $1,000,000 death benefit and then passes away, the heirs will receive the implicit $999,000 gain entirely tax-free. (Notably, certain exceptions to the tax-free treatment of life insurance death benefits apply when the policy was sold to someone else, under the so-called “transfer for value” rules.)

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