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Warning Policy Loans Not Tax-Free

The terms "untaxed" and "tax free" seem similar but can mean a world of difference for life insurance policyholders. 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 it lapse.

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 becomes taxable.

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.

Willard R. Brumbaugh, LUTCF, of Victorville, Calif., is a member of the National Association of Insurance and Financial Advisors, past LUTC chairman, and a moderator of and a contributor to [email protected].

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