 Personal finance powerpoint presentation, life insurance policy, loan and taxes. Preparity gave financially fit by practicing personal finance. Insurance is part of our long-term risk mitigation strategy where we follow the adage of measure twice cut once put in a formal process in place, looking something like set the insurance goals, develop a plan to reach them, put that plan in action, review the results and repeat the process periodically. Most of this information can be found at Investopedia, what are the tax implications of a life insurance policy loan, which you can find online. Take a look at the references, resources, continue your research from there. This by Troy Siegel, updated March 11th, 2022 in prior presentations. We talked about insurance in general, move to the life insurance. We wanna keep the two major categories of life insurance in our mind as we go. That being term or pure life insurance, the one that we always wanna use as our measuring stick or ruler as we move on to other kinds of life insurance like permanent life insurance, keeping those concepts in mind. What are the tax implications of a life insurance policy loan? So typically if you have say permanent life insurance as opposed to term life insurance, you might have that cash component of it and you might possibly be able to take basically a loan using that cash component as collateral in the event that you need to. So taking out a loan against your life insurance policy doesn't count as taxable income. Quick recap with an eye towards the tax implications when we're talking about permanent life insurance as opposed to term life insurance, you're gonna have that cash value or may have the cash value on the permanent life insurance which has an investment component to it. When we're talking about taxes, we're usually talking about income taxes. Therefore if we have income and we have to report the income, that's when we might be subject to the income taxes. That cash value could increase a few different ways. One, you pay for the premiums as you pay the premiums on the life insurance. Part of that might be going into the cash value. And you can think about that as similar to like your principal investment if you would have just put money into a savings account. You're not gonna be taxed on the principal investment but if you earn interest on it or some kind of gains or something like that if there's an increase in value, such as interest, then if it were outside in a bank account you would typically get a 10.99 for the interest and have to record the increase in the value, the earnings as it grows. If it's under the umbrella of the insurance and that cash value, that growth component you may not be paying tax for it. But then of course what happens when you take the money out? It's a little bit confusing now because now you have the original investment which basically was kind of like the money that you put in that you wouldn't think would be subject to tax but then you have that growth component that might be then a taxable component. So if you were to take the money out, the question is can you take the money out without having a tax implication on it or the other option is you take a loan against it. And so oftentimes if you talk about other kinds of tax beneficial accounts like an IRA or a 401K plan there's often restrictions to basically take a loan against it because that's kind of like the same thing as pulling the money out and the whole point of setting up an IRA and the government forcing you to put something under the umbrella of an IRA is that they don't want you to pull the money out but if you use the IRA as collateral then it's kind of like you pulled the money out at the same time, right? So they might put restrictions on that but for the life insurance you can typically do that using the cash value of the life insurance as collateral on a loan. Now because you didn't pull the money out and it's a loan then you would think that even though some of that money in the cash value would be taxable if you were to pull it out because it would be earnings which would have a deferral then because it's a loan and you didn't pull the money out then it wouldn't be a taxable event. However, you might have interest involved. However, that changes if you surrender your policy or the policy elapses and the amount owed exceeds what was paid in. In that case the loan becomes a taxable event a form 1099R so you're gonna get the 1099 which usually indicates a taxable event is issued and you have to pay tax on the loan plus interest at your regular income tax. And this could be in part because basically if you got a loan and you're not basically repaying back all of the loan then you could have basically a taxable event in a similar way if there's like a forgiveness of debt for example. So how much of a loan is taxable? The money you borrowed isn't taxable as long as it's equal to or less than the sum of the insurance premiums you have paid when the policy terminates. And so this gets a little bit confusing with the life insurance because again that cash value isn't just from earnings that have been put into place. It's a little bit more confusing than say like a life insurance, I mean sorry, say with an IRA because when you put money into an IRA you get a tax benefit when you put the money in. So even though you didn't have earnings on it when you put the money in that's your principal investment in other words, you still got a tax benefit because you got to lower your income or have a deduction when you put the money in and all the earnings are of course would be subject to tax if it wasn't under the umbrella of an IRA. When you're talking about the insurance the premiums that you put in you didn't get a tax benefit on. So you would think that when you pull the money out in some way shape or form you wouldn't have a tax consequence possibly on that part. It's the earnings where that you might have a tax consequence on in an event that you kind of pull the money out or terminate the policy in some way. So a taxable amount equals the amount of the gain realized which is any amount you receive from the cash value of your policy minus the net premium cost or the total of premiums paid minus distributions received. Let's say for example that you have a life insurance policy with a cash value of 400,000. You paid 100,000 in premiums but have a 300,000 balance on an outstanding policy loan with no distributions. If your policy lapses the amount you have to claim as income on your taxes is 200,000 because that's the amount over the premiums you paid which you can kind of think of basically as the principle of the investment in essence. So this may be a problem for those whose interest was paid with dividends or the cash value of the policy rather than out of pocket. Out of pocket interest payments aren't tax deductible so taxes are already paid on that amount. But interest payments not made out of pocket often do not cover the entire amount of interest due resulting in compound interest being added to the principle. If your loan sits untouched and accrues interest for decades with minimal interest payments made when a taxable event occurs you may end up owning taxes on a balance that is substantially more than what you originally borrowed. Other considerations for policy loans getting a policy loan is usually quick and easy. So that's one of kind of the benefits of setting up the insurance policies you might be able to get access to basically that cash value in some way or another possibly having a loan against it. So you don't have to go through an approval process because you are borrowing against your own assets. So in other words, you got a cash value in the life insurance policy it may not be able to just pull the cash value out but you might have the option of taking the loan against it because it's collateral the bank is gonna be more safeguard so it's gonna be an easier faster process to do generally. You can use the funds any way you wish. Finally, you don't have a repayment schedule or repayment date. Indeed, you don't have to pay it back at all. However, if the loan isn't paid back before the insured person's death the insurance company will reduce the face amount of the insurance policy by what is still owed when the death benefit is paid. So that's the point of they feel fairly secure as long as it's backed up the loan is backed up by basically the cash value of the insurance company and when you die then they're gonna take a piece of that. The problem with that is that you're hurting the death benefit component of it because it's gonna be taken out of what would be paid out in terms of the death benefit. If you do pay back all or a portion of the loan your options include periodic payments of the principal with annual payments of interest paying annual interest only or deducting interest from the cash value. It's smart to at least make interest payments so the policy loan doesn't grow. So obviously it's kind of nice that you have this complete flexibility if you were to take out one of these types of loans as opposed to basically saying, hey, here's the structure on it. We're gonna be paying it back over this timeframe and we're gonna have set monthly payments for example but clearly you would generally want to be paying at least the interest on the loan so that the principal of the loan doesn't increase. So the accrued interest basically doesn't increase. So clearly you would like to generally put in some plan to be paying back the loan in some way. So in a worst case scenario, if added interest increases the loan value beyond the cash value of your insurance your life insurance policy could lapse and be terminated by the insurance company. So obviously if the loan then goes beyond the cash value well then the insurance company doesn't feel secure about this loan anymore at that point in time and you're gonna have, you could then have of course a problem with the insurance policy. How could that happen? Because if you don't pay back the loan then the interest is gonna keep on going up if you're not at least paying the interest the loan balance is gonna grow. In such a case, the policy loan balance plus interest is considered taxable income by the IRS and the bill could be a hefty one. And I believe that's because they might consider so that you could imagine the insurance companies is gonna say, okay, we're gonna terminate the policy and then policy possibly pay back the loan with kind of like the cash value, but the cash value wasn't really completely yours. There was an insurance contract related to it. So you might have that forgiveness of debt kind of component to it which the IRS would then count as income so that you could have a taxable event that could be significant if that happened. So is a life insurance policy loan taxable? Not really. So usually again, if you take the loan out because it's in the format of a loan, you're gonna pay interest on it which means there's a cost to it but you're not usually gonna be taxed on it because it's a loan. Still be cautious because that changes if you surrender your policy or the policy lapses and the amount owed exceeds what was paid in. So you can have a situation where that happens that we discussed and we'll go and do it. So in that case, the loan becomes a taxable event. What happens to the death benefits if a policy loan isn't repaid? If the loan isn't repaid before the insured person's death, the insurance company will reduce the face amount of the insurance policy by what is still owed when the death benefit is paid. In other words, if you're the policy holder, your beneficiaries get less when you die so pay back those loans. So what is a worst case scenario with respect to policy loans and taxes? If added interest increases, the loan value beyond the cash value of your insurance, your life insurance policy could lapse and be terminated by the insurance company. So they could say, okay, your loan is higher than the balance we're gonna terminate. In such a case, the policy loan balance plus interest is considered taxable income by the IRS and the bill could be a hefty one. So the information continued in this article is not tax or legal advice and is not a substitute for such advice. So disclaimer here, state and federal laws change frequently and the information in this article may not reflect your own state's laws or the most recent changes to the law. So obviously do your own research and disclaimer here when you're taking a look at the insurance options.