Cash value and policy loans: what borrowing from a life insurance policy actually does

Life insurance divides into two broad families. The NAIC's consumer overview of life insurance draws the line: term insurance pays a death benefit if you die during the term and generally does not build cash value, while cash value policies — whole life, universal life, variable life — can be kept as long as you need them and include a feature that lets the owner get money from the policy while still alive.

That feature is where the questions start. "There's money in the policy" is true, and it is also incomplete.

Where the cash value comes from

In a cash value policy, part of what you pay covers the cost of insuring you and the insurer's expenses, and part accumulates inside the contract. The pattern varies by design: the NAIC notes that in some policies the values start low and build later, while in others they build gradually, and it advises asking the insurer to explain the future values before you buy. Your policy contains a table of cash values — the NAIC's answer to "how much cash value is in my policy" is, first, read the policy.

Three different doors

Money can come out of a cash value policy in more than one way, and the doors are not interchangeable.

• A policy loan. You borrow against the cash value; the insurer charges interest. The policy stays in force. The balance doesn't go away on its own.
• A withdrawal or partial surrender, available in some designs, which permanently reduces the cash value and typically the death benefit.
• A full surrender. You end the contract and take the cash surrender value — what remains after any surrender charge and any outstanding loan. The coverage ends with it.

What an unpaid loan does at the claim

This is the sentence worth carrying. The NAIC states it plainly: when you die, the insurer pays the death benefit, and any loans you have not repaid — plus interest — are subtracted from it. The beneficiary can receive less than the face amount.

There's a second effect while you're alive. The NAIC also notes that a policy's cash value may be used to pay premiums, and that if you take cash value out there may not be enough left to do that — in which case the company could require you to resume paying premiums or reduce the death benefit to the amount the remaining value will support. A loan that goes unmanaged for years can, in some policies, put the coverage itself at risk. The remedy is ordinary and unglamorous: ask the insurer for an in-force illustration and see what the policy looks like with the loan running.

The tax layer, in outline

Taxes on life insurance depend on which door you used and on how the contract is classified. The IRS addresses surrendering a policy for cash in Publication 525; the general rules for amounts received under an annuity or life insurance contract sit at 26 U.S.C. §72. A separate classification matters here too: a contract that meets the definition of a modified endowment contract under 26 U.S.C. §7702A — broadly, one funded faster than a statutory test allows — is taxed differently on distributions and loans than a policy that isn't one.

That is the outline, not the answer for your policy. This is general information, not tax advice; your policy's own tax treatment is a question for a tax professional.

Questions that get you a real answer

• What is the current cash value, and what is the cash surrender value — the two differ when a surrender charge or a loan is outstanding.
• What interest rate applies to a policy loan, and is it fixed or variable.
• What does the policy look like in ten years with the loan outstanding — ask for an in-force illustration rather than an estimate.
• Is the contract a modified endowment contract, and would the amount you're planning to put in make it one.

If you hold a permanent policy and want to understand what it can do before you touch it, a licensed agent can read the contract with you — a free conversation, no pressure.