Life Insurance Policy Loans and Withdrawals – how and when to use them

You may have the option of taking a withdrawal or a policy loan against the permanent life insurance that you own. That is because permanent life insurance policies can create surrender value.  Surrender value, commonly called cash value or accumulated cash value, can be withdrawn from the policy, borrowed from the policy, or used as collateral in order to borrow money directly from the life insurance company that issued the policy.

Each of these three scenarios can alter the growth, face value and death benefit of your permanent life insurance policy.

  1. A policy withdrawal  will always reduce your cash values.
    1. If you own a Universal Life Insurance policy, a policy withdrawal could increase the amount of out of pocket expense you will face in order to keep your policy in force and could even force the policy to lapse
    2. If you own a Whole Life Insurance policy, a policy withdrawal will reduce the amount of coverage you have, and it will also reduce any future dividends that you could have earned
  2. Taking a policy loan from a Universal Life Insurance policy:
    1. Reduces your cash values by the policy loan amount
    2. Requires an interest rate payment that is predetermined by your life insurance contract
    3. If the policy loan is not repaid, it becomes a withdrawal
  3. Policy Loans taken against your Whole Life Insurance policy, on the other hand, do not reduce your cash values. Your cash values are instead used as collateral, and therefore they continue to earn growth, contractually guaranteed by the insurance company. However, a policy loan may reduce the dividends your policy would normally generate had a policy loan not been taken
When Should You Take a Life Insurance Policy Withdrawal?

In a Universal Life Insurance policy, taking a policy withdrawal always reduces your cash values. You should be mindful of how much your cash values will be reduced by when taking a withdrawal because the cash values could be reduced to a level that require policy premiums to be paid out of your pocket instead of from your accumulated cash values.

In a Whole Life Insurance policy, reducing your cash values by taking a policy withdrawal will reduce your face value as well as your potential to earn higher dividends in the future.  Knowing this before you take a withdrawal, is important in determining if a withdrawal is right for you.

  • Withdrawals from a Universal Life Insurance policy will reduce your accumulated cash value and reduce the interest you will earn in the policy in the future. But a withdrawal from a Whole Life Insurance policy will actually surrender part of your life insurance coverage (i.e., your face value) and adversely affect any future dividends that you might earn in that policy. 
Tax Ramification of Life Insurance Policy Withdrawals:

It is important to appreciate, that a policy withdrawal can trigger a tax liability for you.  If your withdrawal is greater than your cost basis (premiums you have paid for your policy), then any amount of money over your cost basis in the withdrawal will be considered income for you in the year you take the withdrawal.  Depending on your tax bracket, a policy withdrawal could end up producing a considerable amount of unnecessary and avoidable taxable income.

It is possible that a policy loan could accomplish the same thing you are attempting to do with a withdrawal, without adversely affecting your policy growth or producing a taxable event. This is something of which many policy owners are not aware, and they end up taking needless withdrawals when a policy loan would have been much more productive for them.

How Life Insurance Policy Loans Work:

Universal Life Insurance policy loans are different than Whole Life Insurance policy loans.  With Universal Policy Loans you may have the option of:

1) Borrowing your own accumulated cash values, or

2) Using your accumulated cash values as collateral for a loan from the insurance company

If you chose option one, you will be required to pay your loan back to the accumulated cash value account of your policy at a specified rate of interest determined by your insurance policy contract.  If you opt for number two, you will be required to pay the insurance company back at a specified rate of interest that is determined by your insurance contract.

In the first case, you will be paying yourself interest on your own money.  In the second case, you will be paying the insurance company interest on the money they lent to you.  In either case, you may or may not, be allowed to continue earning the rate of return on the amount borrowed, based on the contract the insurance company provided you at the time you initially started your policy.

Whole Life Insurance policy loans are unique in that you don’t ever borrow your own money from your cash values.  With Whole Life Insurance policy loans, you always use your paid-up insurance as collateral for a loan which the insurance company lends to you.  This keeps your cash values growing at the same guaranteed pace as if you hadn’t taken a policy loan.

In addition to this guaranteed growth, you can continue earning the annual dividend paid to policy holders in Participating Whole Life Insurance contracts.  Some insurers will pay the same dividend regardless of whether there is an outstanding loan against your policy or not (this is called non direct recognition). While other insurers pay dividends on your cash value minus any outstanding loan balance you may have against your policy (this is called direct recognition). You can see more about direct vs non direct recognition here. Either way it is still possible for you to earn dividends while having an outstanding policy loan.

How to Take a Policy Loan:

To initiate a policy loan is simple because it is a signature loan.  You merely sign a loan request form provided by your insurance company, fax, mail or email it to the insurance company, and the insurance company either transfers the money into your bank account or mails you a check by US mail.

  • If the loan is a collateral assignment of your face value, as it is in Whole Life Insurance policy loans, then your policy continues to grows as the binding guaranteed insurance contract outlines
  • If the policy loan is initiated with a Universal Life Insurance policy, then the policy loan request form will require you to choose between borrowing your own money or using your accumulated cash values as collateral for a loan provided by the insurance company

As simple as it is to take a policy loan, you must always account to see if taking the loan is in your best interest.

Why You Should Take a Policy Loan:

Taking a policy loan is a viable solution when you can either make more money or keep more money than you would without taking a policy loan.  This may sound rather simplistic at first, but you must always do the math to assure that a policy loan taken will create more benefit for you than if you didn’t take the policy loan.

For example:

  • If you owe $10,000 in credit card debt and are paying 12% on that debt
  • And you have $10,000 of available cash value to borrow against, and the insurance company’s policy loan rate is only 5%

Your answer is easy.  Keeping 7%, the difference between the 12% and the 5%, is a no brainer.

But what if the interest rate on your debt is only 3%, and your policy loan interest rate is 5%.  Should you take a policy loan to transfer your debt to the insurance company instead of paying that interest to your creditor?  Here is what you need to consider to determine the answer to that question:

  1. What growth will occur in your policy over the time period that you will have the policy loan?
  2. How much time will you take to repay the insurance company for the policy loan?
  3. Can you save money or increase your cash flow by using the policy loan to refinance your debt?

Assume your policy has $10,000 of cash value and it is growing 2.75% annually.  This means, you will have another $1,452.73 on top of that $10,000 in cash values in 5 years.

  • If you pay minimum payments on your $10,000 debt at 3%, you will end up paying your creditor $10,917.73 over 5 years
  • But borrowing against your policy to pay off your $10,000 would allow you:
    • To earn $1,452.73 over the next five years in the policy
    • While paying 5% interest to the company, or $1,548.74 of interest over 5 years
  • The $1,452.73 of policy growth is yours to keep
  • The $1,548.74 which you now pay to the insurance company is $96.01 greater than the $1,452.73 of interest the policy generated for you
  • Which effectively adds another 17 basis points to your 2.75% policy earnings

Without any policy to borrow from you would have lost the policy growth of $1,452.73, along with the $917.73 of interest you would have paid your creditor.  This interest, plus your unrecognized policy cash value growth, would have been an unseen cost to you of $2,369.46.

With the policy, you keep about 55.35% ($1,548.74) of what you would have lost ($2,369.74) without the policy.  That is why you must always do the math.

6  Reasons to Take a Life Insurance Policy Loan:
  1. When you can make more with the money from the policy loan than what you will have to pay in interest for the policy loan
  2. When you can transfer debt and manage to keep more money than if you kept the original debt and paid if off
  3. When you need to free up monthly cash flow and are borrowing from your policy to retire more demanding monthly obligations, then
    1. You will want to set up payments back to your policy that are more comfortable and affordable for you but over a longer period of time, so that taking the loan is profitable for you
  4. When you need a quick influx of capital, but can’t secure a cheaper source to access the needed capital
  5. To increase your cash flow in retirement
  6. To protect spending down your 401k or IRA in a market down turn
5 Reasons NOT to Take a Life Insurance Policy Loan:
  1. When there is a danger that you cannot earn more than what the interest on the policy loan will be
  2. If you never intend to pay the policy loan off
    1. Unless you are retired, or
    2. You are generating enough with the money borrowed against the policy to pay the interest on the loan and still earn a profit
  3. To fund another insurance policy indefinitely
  4. To speculate rather than make good investments with the proceeds of the policy loan
  5. To meet revolving living expenses consistently
    1. Unless you are retired and you are spending down your cash value, or
    2. You are financing specific living expenses and are paying those loans off prior to borrowing again to finance another living expense

Life Insurance policy loans are a huge benefit to those who understand their limitations, availability and flexibility.  They are a good way to help you manage your money better allowing you to keep more of what you make while building a more sustainable financial future that will be tax exempt for you and your loved ones as well.  But as with any loan, you should always be aware of the implications and complications that can occur when you take a policy loan.  Policy loans are not the panacea that many insurance agents paint them up to be abusing concepts such as The Infinite Banking Concept, Bank On Yourself, etc.  But they are a viable options  if you see the power of managing your own money instead of paying others a fee to manage it for you.


Dr. Tomas McFie Dr. Tomas P. McFie

Most Americans depend on Social Security for retirement income. Even when people think they’re saving money, taxes, fees, investment losses and market volatility take most of their money away. I help people beat the system with a financial formula that minimizes taxes, reduces fees and cuts losses so they can keep more of the money they make, grow their wealth and never run out of money.