Regular reviews of inforce life insurance policies are essential and can uncover important planning opportunities. While conducting a policy review, advisors may uncover an older policy that has a significant policy loan. If not addressed, these policies can become a tax time bomb. When it comes to policy loans there are 4 available options to weigh, all of which have their own set of benefits and considerations.
Policy loans incur interest charges. Since interest is typically accrued internally to the policy, over time the loan will continue to grow and erode policy cash values. Should the policy lapse, there can be substantial phantom gain equal to the outstanding policy loan less the policy cost basis. The gain upon lapse of the policy will be subject to income taxes (at ordinary rates) and there will be no funds to pay those taxes. If in addition to policy loans, partial withdrawals of policy cash values were also taken as a tax-free return of premiums, the cost basis in the policy will have been correspondingly reduced creating an even greater taxable gain.
For example, assume that in years 1-5 the client paid $500,000 of premiums into a permanent UL policy. The client took partial withdrawals of $100,000/year in years 11 – 15, reducing his cost basis to zero. The client continued to borrow $100,000/year for years 16-25. In year 26, the policy lapses without value, with an outstanding loan (including accrued loan interest) equal to $1.3M. With no basis in the policy, the client recognizes $1.3M of ordinary income or $520,000 of income taxes based on a 40% rate. With no remaining cash values to pay those taxes, the taxes are an unexpected out-of-pocket expense.
Twenty Years Later
Alternatively, suppose that you encounter this client in policy year 20, after the client has taken five policy loans of $100,000 each. You offer a complimentary policy review emphasizing the lapse issue and that there is still time to evaluate and remedy the situation.
Five Questions to Ask About a Loaned Policy
As part of the policy review process, it is essential to evaluate the current and projected effect of the policy loan.
- Is there a current gain and what is the policy’s cost basis?
- Will the policy stay in force or can it be expected to lapse?
- If so, when does it lapse and what is the estimated gain at that time?
- Is there a crossover year, before which there is sufficient cash to pay the estimated gain if the policy were surrendered?
- Are new and more favorable types of coverage available?
It will be necessary to acquire information from the carrier as to the premium history, including any partial withdrawals of policy cash values, the gain, if the policy were surrendered today, and the in-force ledger. Only the incumbent carrier can provide this information and an advisor should not make assumptions as to what the cost-basis and gain are in the given policy.
Four Options When Dealing with Policy Loans
Armed with this information and based on the client’s need for coverage, four options can be considered:
- Do Nothing. The client can take the chance that the policy may lapse and that taxes may be due, if there is a gain on the policy. This option may be feasible if the client is in poor health or if the need for the insurance is limited in time, i.e. the policy will be surrendered while sufficient cash values remain to pay the tax on the gain. In any case, to avoid unpleasant surprises the performance of the policy should be monitored closely over time.
- Repay the Loan from Funds Outside the Policy. The client may be willing to repay the loan from funds that are not from the policy. It is also possible for the client to surrender the policy and ‘roll over’ the full cash surrender value, net of the loan and charges, into a new policy.
- Cash in the Policy and Deposit the Net Cash Value in a New Policy. Even if there is no gain, or even a small amount of gain, the client may be willing to pay the tax on it and ‘roll’ the net cash value into a new policy.
- Exercise an IRC §1035 Tax-free Exchange to A New Policy and Subsequently Repay Loan. Exchanging the policy for a new one that ‘mirrors’ the loan amount may provide a higher death benefit and lower loan interest charges. The loan on the new policy can then be repaid either out-of-pocket, or from policy values over time. As a rule-of-thumb, the loan can be repaid from the policy’s cash values in year 2 or later to avoid triggering taxes. It is important to run illustrations showing the effect on the policy’s long-term performance when the loan repayment is made from the cash values, delayed, or not made at all.
Three Benefits of Executing a 1035 Exchange of a Loaned Policy
The benefits of exchanging an older policy with a new one can be summarized as follows:
- The new policy may provide a higher death benefit than the old policy;
- The new policy may have an extended guarantee and additional riders that provide lifetime benefits to the insured, such as funds to cover chronic illness, long-term care or critical illness coverage; and
- When properly structured, a 1035 exchange that includes the original loan allows the policyholder to avoid taxation on the gain or the loan.
Eight Key Consideration When Dealing with a 1035 Exchange of Loaned Policies:
Advisors and their clients should consider the following when evaluating a 1035 exchange of an older policy with a loan:
- When using cash values to repay the loan, surrender charges will likely apply – the earlier the loan is repaid the greater those charges and the death benefit will be reduced. Ongoing premiums may be required.
- If the loan is repaid before the 1035 exchange is executed using the policy’s cash values, the client will incur taxes on taxable income equal to the lesser of the loan amount repaid or the built-in gain in the policy (“boot”).
- In many cases, it will be desirable for the policyowner to repay the loan as early as possible. If the loan is not repaid, the policy’s performance must be reviewed regularly to ensure that it does not lapse.
- Loan repayment is not automatic. It is imperative that the advisor monitors the policy loan and helps the policyowner initiate the process to repay the loan according to the carrier rules.
- If the policy is owned by an unfunded insurance trust and the client is considering repaying the loan with assets other than policy cash values, the gift and generation skipping transfer tax consequences must be considered.
- Gain on the policy is determined by the carrier, not the advisor. If the carrier determines that there is gain, the policyowner will receive a 1099 from the carrier, on which the taxable amount will be included in box 2a.
- It is up to the client’s legal and tax advisors to determine how soon the loan can be repaid after executing the 1035 exchange.
- Even if there is no gain in the existing policy, it may be desirable to execute a 1035 exchange and carry the basis forward to the new coverage.
Conducting a policy review can go a long way in helping clients course-correct life insurance coverage including addressing potentially problematic policy loans and changing needs over lifetime.
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 In a 1035 exchange with a policy loan, the new carrier must agree to accept a loaned policy in the exchange to a new one. In doing so, the new carrier technically repays the loan on the old policy to the incumbent carrier and books a loan on the new policy. For this reason, the loan is not characterized as being ‘carried over’ since the original loan must be repaid. Rather, the loan is factored into the new policy. This is sometimes referred to as a ‘mirrored loan’.