The terms "untaxed" and
"tax free" seem similar
but can mean a world
of difference for life
Policy loans are not tax-free.
The improper use of the term "tax
free" could get agents and insurance
companies in big trouble. This term has
caused definable harm to some of our
clients and to our industry's reputation.
At one time, the interest on policy
loans was deductible when four years'
worth of premiums, out of the first
seven, had been paid in full. But then
the law was changed so the interest
would be deductible against earnings
only when the loan was for a genuine
business transaction. Any other loan
interest has been deemed consumer
interest and, therefore, is not deductible.
When our clients use borrowing
as a way to supplement their income,
these loans are considered consumer
debt, and the interest is not deductible.
As this interest continues to grow,
the interest on the accumulation value
of the policy also grows and, with
proper planning, the surrender value
of the policy remains greater than the
accumulated loan. This is good use of
the whole life or universal life policy.
But this becomes a problem if, for
any reason, the policy terminates
before the insured dies, because all the
interest that exceeds the cost basis of
the policy, without accounting for the
loan interest, becomes taxable.
As a participating advisor at Allexperts.
com, I received a complaint
from a man who trusted our frequent
description of policy loans as being
tax-free. This is his story:
Back before we had the concept of
modified endowment contracts, the
client purchased a single-premium,
whole life policy for $100,000, with
the specific intent of creating an
unreportable, untaxed supplemental
income stream. In the early 1990s,
his insurance company was acquired
by another company. The acquiring
company perpetuated the belief that
the client's loans were tax-free.
Late last year, the client received a
letter stating that the surrender value
of the policy had been consumed and
he needed to reduce the loan to keep
the policy in force. At the age of 79,
and in need of money, he decided to let
As a result of his decision, the
client received a 1099 for $235,000.
Most of this $235,000 was "phantom
interest." This was interest he would
never get to spend but was being
taxed on anyway. As mentioned
above, policy loans meant to supplement
income generate consumer loan
interest, which is not deductible. This
interest does not offset the interest
accumulating in the cash value of the
life insurance policy, so this functionally
nonexistent interest becomes
taxable when the policy is terminated.
To illustrate: Assuming that he
had received $6,000 per year for 24
years, this client would have received
$144,000 as unreported supplemental
income. This series of loans at 6.25 percent
interest creates a debt of $335,013.
This is the minimum accumulation
value needed to keep the policy from
lapsing. This minus the initial $100,000
becomes the taxable gain for which the
79-year-old retiree must pay income
tax. It is for this "phantom interest"
that the policy owner is taxed when the
policy terminates prior to death.
This policy owner was not directly
taxed on the money he received. He
was taxed on the entire loan in excess
of the initial premium. Here is what he
needed to know and what we should
have been telling our clients: Policy
loans are untaxed and remain untaxed
until the policy is terminated by
anything other than death.
Policy loans are considered by the
IRS to be applied against the death
benefit. Since in most cases the death
benefit is not subject to income tax,
there is no income tax on the loans.
But when the policy is terminated prior
to death, there is no death benefit to
pay off the loan. All untaxed interest
This is why we must refer to policy
loans as untaxed, not tax free. By calling
loans untaxed instead of tax free, we
are not only being more accurate, but
we also may be saving our livelihoods
and assets. I truly believe that doing
otherwise opens us up to lawsuits.
The gentleman who wrote me
regarding his experience expressed his
disappointment with our industry. He
no longer trusts us. We may not be able
to regain his trust. But we must do what
we can to keep the trust of others.