The Life Insurance Loan Tax Bomb On Lapsing Policies

The Life Insurance Loan Tax Bomb On Lapsing Policies

As noted earlier, when a life insurance policy is surrendered in full, the gains on the policy are taxable (as ordinary income) to the extent that the cash value exceeds the net premiums (i.e., the cost basis) of the policy.

Because, again, a life insurance policy loan is really nothing more than a personal loan from the life insurance company to the policyowner, for which the policy’s cash value is simply collateral for the loan

As a result, if a life insurance policy is surrendered to repay an outstanding life insurance loan, the net transaction can have tax consequences – not because the repayment of the loan is taxable, but because the surrender of the underlying policy to repay the loan may be taxable.

Example 3. Sheila has a life insurance policy with a $105,000 cash value, a $60,000 cost basis, and a $30,000 loan. In the event that Sheila surrenders the policy, her total gain for tax purposes will be $45,000, which is the difference between the $105,000 cash value and her $60,000 cost basis. Notably, the tax gain is the same $45,000, regardless of the presence of the $30,000 loan. If Sheila didn’t have the loan, she would receive $105,000 upon surrender of the policy; with the loan, she will only receive $75,000, because the remaining $30,000 will be used to repay the outstanding loan.

Either way – whether Sheila had received the $105,000 value (without a loan) or only $75,000 (after repaying the loan) – the taxable gain is the same $45,000

In this context, the reality is still that the life insurance policy loan itself has nothing directly to do with the taxation of the transaction. The policyowner did use the proceeds from surrendering the policy to repay the loan, but the tax consequences were determined regardless of the presence of the life insurance loan.

In the preceding example, the presence of the life insurance policy loan reduced the net cash value received when the policy was surrendered, even though it didn’t impact the tax consequences of the surrender. Given how much cash value was available, though, this wasn’t necessarily “problematic”; it simply means the policyowner would use a portion of the $75,000 net proceeds to also pay any taxes due on the $45,000 gain.

However, the situation is far more problematic in scenarios where the balance of the life insurance policy loan is approaching the cash value, or in the extreme actually equals the total cash value of the policy – the point at which the life insurance company will force the policy to lapse (so the insurance company can ensure full repayment before the loan collateral goes ‘underwater’).

The reason is that in scenarios with a large loan balance, the fact that there may be little or absolutely no cash value remaining does not change the fact that the tax gain is calculated based on the full cash value before loan repayment.

As a result, the lapse of a life insurance policy with a large loan can create a “tax bomb” for the policyowner, who may be left with a tax bill that’s even larger than the remaining cash value to pay it.

Example 4. Continuing the prior example, assume that Sheila had accumulated a whopping $100,000 policy loan against her $105,000 cash value, and consequently just received a notification from the life insurance company that her policy is about to lapse due to the size of the loan (unless she makes not only the ongoing premium payments but also 6%/year loan interest payments, which she is not payday loans in Sweetwater TN interested in doing).

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