Permanent cash-value life insurance, such as indexed universal life insurance, is commonly touted as a wealth-building tool. Indeed, positioning money in an insurance policy can offer you the benefits of growth without the capital gains and dividends taxation normally applicable in brokerage accounts.

It is likely that these policies have been pitched to you with the promise of tax-free loans in retirement. Policy loans issued by an insurance company that use the policy’s cash value as collateral can be confusing and also potentially detrimental to cash-value buildup.

Policy loan provisions are found only in cash-value policies. Cash values accumulate after the policy has been in force for a defined period of time. Although one can surrender or cash in a policy, a partial withdrawal or loan is also possible.

A policy owner can obtain a loan up to the amount of the cash value in the policy minus any indebtedness (such as prior loans and interest payable) outstanding against the policy.

Loans are treated as debts and not as income or taxable distributions and therefore no income tax is due on money accessed via the policy loan. This has led to the use of the term “tax-free income” to describe cash-value life insurance and policy loans.

Modified endowment contracts (MECs) have different taxation rules. In order for a policy to qualify for standard insurance income tax treatment, IRS code limits the amount of premium paid under a permanent cash-value life insurance policy in the first 7 policy years. If excess premiums are paid, the policy becomes classified as a MEC.

TAXING RULES

Taxation under a MEC is similar to taxation under an annuity. Under a MEC, income taxes are not due on the gain unless funds are distributed as full or partial surrenders or policy loans. MEC loans are, therefore, taxable.

With an MEC, full and partial withdrawals and loans are taxed as interest first, as opposed to premium first under a regular life insurance policy. In addition, taxable distributions prior to age 591/2 are typically subject to a 10% penalty.

Borrowing cash from a policy incurs interest, as would any bank loan. The adjustable, or fixed, interest rates charged by the insurer are regulated by the state. Those rates will often be reduced if the owner agrees to pay the interest in advance.

Conversely, if the loan is paid at the end of the year, the interest due will be greater. Interest is charged as long as a loan is outstanding and is added to the principal, where it will accrue and compound.

The policyholder may both pay the yearly interest due on the loan and make principal payments in any amount to reduce indebtedness. Policyholders, however, are not required to pay back loans.

Outstanding loans and in­terest will reduce the benefits payable to the beneficiary upon the death of the insured or the cash value payable to the policyholder upon surrender.

In general—and with most policies that are in effect for a number of years—failure to repay the loan and interest will not void the policy unless the indebtedness exceeds the current cash value.

Prior to cancellation of the policy, the insurer may also provide a grace period. If a policy loan is still outstanding when the policy is surrendered, or it lapses, the amount of the loan plus interest will be considered taxable income to the extent that there is gain in the policy.

See also “All About Insurance” by Cheryl Whitman in the June 2006 issue of PSP.

Automatic premium loans, when included, allow the insurance company to use a portion of the cash value to pay premiums when they become due. This provision keeps a policy in force that would otherwise lapse due to nonpayment of premiums. The policy must have sufficient cash values to pay the premiums due.

Automatic premium loans also accrue interest and can similarly reduce cash values. These loans are usually invoked at the end of the grace period.

Wash loans—or zero-interest loans—are special types of loans in which the interest charged equals the growth rate in the policy. Therefore, the cash value will not be used to repay an outstanding loan. For example, if the loan is charged a rate of 6%, the cash value will also be credited 6% on the same amount. This will result in a neutral or wash transaction.

In variable loans, an interest rate is still charged but the cash value-crediting rate is variable. The difference between the interest charged and the interest credited can be zero, positive (where interest would be due), or negative (where the policy owner would make money).

Mervin Low, MD, CWPP, CAPP, is a plastic surgeon who practices in Southern California. He also is a certified wealth-preservation planner and a certified asset-protection planner. He can be reached at .