Kitces: When a life insurance policy sends out an S.O.S.
January 7, 2017 by Michael Kitces
As some clients may have realized, loans against cash-value life insurance policies can be made at relatively favorable interest rates. However, those clients run the risk of a substantial tax liability if the loan compounds out of control. This can happen whether the loan was a proactive “bank on yourself” borrowing strategy or just a loan that accidentally was allowed to accrue too far over time.
For advisers who have clients that come in with existing life insurance policies carrying substantial loans, it’s important to understand the ins and outs of the process to rescue the policy before an adverse tax consequence results.
THE WARNING SIGNS
A life insurance policy loan is ultimately nothing more than a personal loan from a life insurance company, for which the policy’s cash value serves as collateral. The policy owner can never be on the hook for a loan that’s greater than the available cash value, but if the policy must be liquidated to pay off the loan, the owner may still receive a Form 1099-R for the underlying gains (even if there’s no cash value remaining to pay the taxes).
Take this hypothetical example of a woman who has paid $125,000 of premiums into a universal life policy. The policy has a current cash value of $200,000. Many years ago, she borrowed $100,000 against the policy, and after more than a decade of compounding loan interest, the balance has reached the $200,000 cash value.
Consequently, the policy lapses, and the insurance company keeps the $200,000 cash value proceeds to pay off the loan. However, since the policy was worth $200,000 at liquidation, and the cost basis was only $125,000, our subject will receive a Form 1099-R for $75,000 and has to pay taxes on the gain — even though she doesn’t receive any cash upon liquidation.
TO THE RESCUE
In such cases it may make sense to try rescuing the life insurance policy, either to avoid the adverse tax consequences or simply to retain the value of the death benefit itself.
There are various rescue strategies, all of which share a common starting point: a thorough evaluation of the current policy. Key information that must be gathered includes (amongst other factors) the policy type, ownership structure, beneficiaries, the original underwriting classification, and getting an in-force ledger.
Once this background has been gathered, it’s feasible to start evaluating potential strategies.
RESTRUCTURING
The first approach is to restructure the policy in an effort to help it survive longer.
One restructuring possibility is to change the dividend option. For any permanent policies that are paying a dividend, there are several paths available for how dividends will be used. The most common — and often default — option is to purchase Paid-Up Additions, which, as the name implies, are small amounts of additional coverage that are fully paid up when purchased. The good news about PUAs is that they’re quite favorably priced for additional insurance, in part because they include no acquisition costs. The bad news is that if there’s a compounding loan, buying more insurance while the main policy flounders is not a sound strategy.
Fortunately, the dividend option can be changed and redirected to pay the loan interest (or principal, or both) with just a simple request to the insurance company. If the dividends are large enough, they may eventually extinguish the loan, allowing the policy to sustain. And after that point, the dividends can be directed toward purchasing PUAs again.
DEATH BENEFIT REDUCTION
The next option to improve the sustainability of a policy is to restructure the cash value or death benefit.
If it’s a universal life policy, the death benefit can be reduced. In the case of a whole life policy, this is accomplished through a partial surrender (either of the base policy, or its PUAs), which may trigger some taxation. Either way, less death benefit means less ongoing cost of insurance charges, which can improve the sustainability of the policy.
The obvious downside to reducing the death benefit is that it literally reduces the death benefit. But for those just trying to ensure the policy remains in force, a reduction may be more appealing than a total lapse.
Another option for a universal life policy is to take a withdrawal from the cash value itself, and use the funds to pay down the loan balance. Provided the policy is not a Modified Endowment Contract or subject to a “force-out” for overfunding under IRC Section 7702B, withdrawals from a universal life policy are treated as a basis-first return of principal, and are not taxable until all basis has been recovered. This provides a means to take a tax-free withdrawal from the policy, and use it to immediately repay a portion of the loan.
Notably, depleting the cash value with a withdrawal may mean the policy will ultimately need another contribution — i.e., more premium payments — to sustain in the long run. Nonetheless, if the cash value is spiraling toward lapse anyway, a withdrawal to repay the loan will at least help extend the life of the policy.
MORE CASH
Beyond restructuring the policy to improve its longevity, the next option is simply to put more money in.
To the extent the loan balance is reduced by an infusion of outside dollars, the rate of compounding will slow, while the likelihood of the policy lasting until it matures will increase. If the loan can simply be repaid altogether, then the entire issue is resolved.
This strategy is especially appealing if the policy owner carries a substantial amount of money in a bank account or a large bond allocation, as it makes little sense to have dollars in a money market or bond paying 1% to 3% while a life insurance policy loan simultaneously accrues at 4% to 6% or more.
If there isn’t enough money available to fully repay the loan, the next way to rescue the policy is to at least pay the annual loan interest, which prevents the loan from compounding further.
Of course, this presumes that the policy owner is otherwise making the necessary premium payments in the first place. In fact, the failure to pay life insurance premiums is often what triggers problematic loan situations in the first place, either because it’s a whole life policy that forces premiums to be paid via the Automatic Premium Loan provision, or because it’s a universal life policy that has insufficient cash value to keep up with all costs and charges while the loan accrues. To the extent that premiums aren’t being paid, reinstating them can help slow a bad loan situation from getting even worse.
THE 1035 EXCHANGE
If restructuring the policy with a loan isn’t enough, and the policy owner is unwilling or unable to put additional cash into the policy to support it, the next option is policy replacement, where the original policy is exchanged for a loan to a new policy that may be more sustainable.
Among life insurance agents, replacing a policy with a loan for another one is usually the primary approach to executing a life insurance loan rescue — in part because the agent often stands to earn a substantial commission.
That an agent would be compensated for executing a good policy replacement isn’t necessarily a bad thing. Unfortunately, though, the commission incentive may cause the insurance agent to lead with this approach, rather than looking at the aforementioned options of restructuring or adding more cash first.
In some cases, however, a replacement may be the only option. An improvement in the insured’s health sometimes even makes it appealing to do so. In other cases, there’s no change in health, but it’s still possible to replace with a more favorable policy simply because the original one wasn’t shopped around aggressively in the first place.
Additionally, today’s life insurance policies may offer more favorable loan provisions than policies of the past did. For instance, many policies provide that the loan interest rate be simply the current crediting rate, plus a spread of 0.5% to 1% — which, combined with a low 3% crediting rate, means the loan interest rate might be as low as 4%. By contrast, loan interest rates of 6% or even 8% proliferated on policies issued in the 1980s and ‘90s.
The new replacement policy could consequently be far more sustainable than the original, simply because the loan interest rate will compound more slowly.
An important caveat of doing a 1035 tax-free exchange to rescue the old life insurance policy: It’s essential that the new policy still take on an identical loan. In other words, the exchange should still be for the gross cash value of the life insurance policy, with a loan attached. If a policy with a loan is exchanged for a policy without a loan, the policy holder is treated as having received a partial liquidation of the policy, which triggers income tax consequences.
For instance, consider a man who has a $750,000 universal life policy with a $200,000 cash value and a $150,000 outstanding loan balance — and thus a net surrender value of $50,000. If he does a 1035 like-kind exchange from his current life insurance policy to a new, smaller policy for just the $50,000 of net cash value, he’s treated as having exchanged $50,000 of cash value plus receiving another $150,000 of cash to boot, which was used to repay the loan. Furthermore, that $150,000 is taxable as a partial surrender of the policy. To avoid this so-called boot treatment, it’s essential that our individual’s new policy be a $200,000 cash value with a $150,000 outstanding loan balance, precisely matching the original.
Fortunately, it’s possible to get a replacement policy with a loan, but such transactions are not standard. Instead, it is necessary to request a version of the life insurance policy that can accept an incoming loan — which at many companies is dubbed a “life insurance loan rescue policy” because it’s put to this exact use. Genworth, Zurich, Voya and Lincoln all offer life insurance loan rescue policies.
If a replacement policy loan rescue is being contemplated, though, it’s crucial to still thoroughly vet the replacement policy itself — most notably, how the life insurance cash value will be invested, and whether it is being illustrated at an appropriate rate or not. For instance, determining the appropriate rate for an indexed universal life policy is highly controversial in today’s environment, and forecasting a higher-than-realistic growth rate could make the exchange look appealing, but ultimately cause the replacement policy to get into trouble in the future, re-creating the exact problem that the replacement policy was intended to avoid.
The same caution goes for replacement policy loan rescues that refinance using a premium financing strategy. This practice can potentially lower the loan interest rate, but again might create unforeseen problems if interest rates rise but the life insurance policy’s crediting rate doesn’t keep up.
SURRENDERING A POLICY
The last option for a policy that can’t be effectively rescued is to just let it go.
The most straightforward way to do this is simply to contact the insurance company and request a surrender. To the extent there is any positive cash value remaining, the proceeds will be sent to the policy owner.
As with any policy that has a substantial loan, the taxable gain will still be based on the gross cash value before repayment of the loan, which means it’s possible that most if not all of the cash-value proceeds will be consumed by the tax liability. Still, getting at least some cash value out of the policy — to help cover the tax gain — is better than getting no cash value out of it at all by allowing a problematic loan to compound until the cash value really is zero.
For policy holders in their 60s or older, another alternative is a life settlement transaction, which involves the sale of a life insurance policy to a third-party buyer/investor. In such cases, the buyer may pay more than just the remaining net cash value surrender after repaying the loan, leaving the former policy owner with more cash in his/her pocket. This transaction is still taxable, but a life settlement for an amount greater than the cash value nonetheless gives more dollars to help pay the taxes. And once the buyer takes over the policy, he/she is responsible for sustaining the loan as well.
For those who just don’t want the cash flow obligation of maintaining the policy given a substantial loan, and are at least in their 60s with some health conditions, getting full value from a third-party buyer in a life settlement transaction is generally a better way to salvage what’s left of the policy’s remaining value, rather than simply surrendering it to the insurance company for its cash surrender value.
MONITORING IS KEY
Because most life insurance policies have several moving parts — from crediting and loan interest rates to dividends on participating policies — it’s still necessary to have a proactive monitoring process. Otherwise, there’s a risk that a rescued policy could take a downward turn, which if not caught and corrected quickly, could just necessitate yet another rescue down the road.
Still, a life insurance policy with a loan — even a substantial one that was neglected and allowed to compound for years — often can be saved, at least partially. Taking steps to engage in a rescue can at least potentially ensure that a depleting cash value doesn’t turn into a forced policy lapse — and a big tax liability.
