Exercise Caution When Borrowing Against a Whole Life Insurance Policy

A whole life insurance policy can be a useful and versatile part of an estate plan. It grows in value over time, increasing the value of the asset left to your loved ones in the event of your passing. Adding to its appeal is that you can borrow against the policy when needed and the time line for repayment on the loan has flexibility. Sounds good in theory, however this benefit can be hazardous if not managed properly!  Here's why:

In some cases, a policy holder can avoid repaying both loans and interest, for years or even decades. The insurance company will simply capitalize the interest, adding it to the loan principal at the close of the year. The trouble arises when the loans and interest exceed the policy’s cash surrender value (which is the money that grows over time inside the savings component of the life insurance policy).

When the cash surrender value is exceeded by the outstanding loan and interest, the insurance company will send a notice stating that a minimum payment must be paid within 30 days or the life insurance policy will be terminated, and a taxable event may occur. This minimum payment can be substantial, and if the policy holder fails to make the payment, the life insurance policy terminates and the insurance company extinguishes the debt.  Extinguished debt sounds like a good thing right? Wrong.

The insurance company will also file a 1099-R form with the IRS stating that the amount owed beyond the initial premium is income distributed to the policy holder, thus making the policy holder liable on their next income tax filing for a substantial increase in their income, even though the increase happened over the course of several years. The following example, based on an actual policy holder’s experience, will illustrate this point:

Bill purchases a whole life insurance policy with a one-time premium of $50,000. Over the next ten (10) years, bill borrows a total of $110,000 against the policy and allows the interest to capitalize every year without making any repayments, ultimately accruing $85,000 in interest. Bill has now exceeded the cash surrender value, and the insurance company informs him that he must make a minimum payment  of $21,000 within thirty (30) days to avoid termination of the policy. If Bill fails to make the payment, the IRS will receive a report that he has received a distribution of $145,000 in taxable gross income (the total value of the debt and interest minus his initial premium).

Because they did not receive a distribution at the time of the termination of the policy, policy holders often fail to declare the income reported on the 1099-R form. This failure to declare will result in significant penalties from the IRS, and the Courts are far from sympathetic in these circumstances.

As was stated at the outset, a whole life insurance policy can be a wonderful feature to an estate plan, but it takes professional to guidance to ensure that it is used properly. The attorneys at Altman & Associates have experience in helping clients leverage complex financial instruments. Call us at (301) 468-3220 to set up an initial consultation.

- Christopher J. Martin, Esq. and Gary Altman, Esq.

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