In a recent post, Michael Kitces discusses the very common and well regarded life insurance policies that many have but also the less often considered taxation of such policies. He explains,

However, while a life insurance loan isn’t taxable – nor is its subsequent repayment – the presence of a life insurance loan can distort the outcome if/when a life insurance policy is surrendered or otherwise lapses. Because the insurance company will require that the loan be repaid from the proceeds of the policy.

In the case of a life insurance death benefit, this isn’t necessarily problematic. The death benefit is already tax-free, and the loan is simply repaid from the tax-free death benefit, with the remainder paid to heirs.

When a life insurance policy is surrendered or otherwise lapses, though, the remaining cash value is again used to repay the loan… even though the taxable gain is calculated ignoring the presence of the loan. Which means in the extreme, it’s possible that a life insurance policy can lapse without any remaining net cash value, due to a loan repayment, yet still produce a significant income tax liability based on the policy’s gains. This “tax bomb” occurs because in the end, even if all of a policy’s cash value is used to repay a life insurance loan, it doesn’t change the fact that if the policy had a taxable gain, the taxes are still due on the gain itself!

Continue reading his full opinion here: Life Insurance Policy Loans: Tax Rules And Risks

Posted by Allison Trupp, Associate Editor, Wealth Strategies Journal