LIFE INSURANCE POLICY LOANS AND WITHDRAWALS
Kelly Insurance Group explains how policy loans and withdrawals from permanent life insurance work — the critical differences between them, the tax treatment of each, the impact on the death benefit, and how to access cash value without inadvertently triggering a lapse or tax consequence.
HOW LOANS AND WITHDRAWALS DIFFER — AND WHY THE DISTINCTION MATTERS FOR YOUR POLICY.
| FACTOR | POLICY LOAN | WITHDRAWAL |
|---|---|---|
| DEFINITION | Borrows against cash value — it remains in the policy and continues to grow | Permanently removes cash value from the policy |
| TAX TREATMENT | Tax-free — a loan is not income | Tax-free up to cost basis; gains above basis are taxable |
| DEATH BENEFIT IMPACT | Reduces death benefit by outstanding loan balance if insured dies before repayment | Permanently reduces death benefit by amount withdrawn |
| CASH VALUE IMPACT | Cash value remains and continues to earn interest/dividends | Cash value is permanently reduced |
| REPAYMENT REQUIRED | No fixed schedule — but interest accrues; unpaid interest adds to loan balance | Not repayable — the reduction is permanent |
| POLICY LAPSE RISK | Yes — if loan balance plus interest exceeds cash value, policy can lapse with tax consequences | Yes — if withdrawals deplete cash value below minimum required to sustain coverage |
| BEST FOR | Large amounts, short to medium term access, preserving death benefit | Small amounts, permanent reduction acceptable, above cost basis taxable |
HOW TO ACCESS CASH VALUE WITHOUT ACCIDENTALLY DESTROYING YOUR POLICY.
AN UNPAID POLICY LOAN CAN CAUSE THE POLICY TO LAPSE — WITH A SIGNIFICANT TAX BILL
When a policy loan is taken, interest accrues on the outstanding balance. If the loan balance plus accrued interest exceeds the policy's cash value, the policy lapses. At lapse, the outstanding loan balance — including accrued interest — is treated as a taxable distribution to the extent it exceeds the policy's cost basis. This tax consequence can be substantial on a policy with years of accumulated gain. Monitor loan balances and interest accrual to prevent lapse.
LOANS ON A MODIFIED ENDOWMENT CONTRACT ARE TAXED DIFFERENTLY
On a non-MEC policy, loans are tax-free regardless of the gain inside the policy. On a Modified Endowment Contract — a policy funded too quickly, including most single premium policies — loans are treated as taxable distributions to the extent of gain, and a 10% penalty may apply before age 59½. Confirm whether your policy is a MEC before taking a loan if tax treatment matters.
THE DEATH BENEFIT REDUCTION FROM AN OUTSTANDING LOAN IS OFTEN OVERLOOKED
A policyholder who borrows $100,000 against their policy and dies with the loan outstanding leaves their beneficiary a death benefit reduced by $100,000 — plus any accrued interest. This is disclosed in every policy but is frequently forgotten in the years between the loan and the death. Tracking outstanding loan balances and their impact on the net death benefit is part of an ongoing policy management responsibility.
EXPLORE MORE PERMANENT LIFE INSURANCE RESOURCES
FREQUENTLY ASKED QUESTIONS.
Is a policy loan taxable income?
Generally no — a policy loan from a non-MEC life insurance policy is not taxable income regardless of the policy's gain. The loan is treated as a debt, not a distribution. However, if the policy lapses with an outstanding loan balance, the loan is treated as a taxable distribution to the extent it exceeds the policy's cost basis in the year of lapse.
Does taking a policy loan reduce my death benefit?
Yes, but only if the loan is outstanding at the time of death. If the insured dies with an outstanding loan balance, the death benefit paid to the beneficiary is reduced by the outstanding loan plus any accrued interest. If the loan is repaid before death, the full death benefit is paid.
Can I repay a policy loan?
Yes — policy loans can be repaid at any time and in any amount. There is no required repayment schedule. However, interest continues to accrue on the outstanding balance until it is repaid. Paying at least the annual interest charge prevents the loan balance from compounding and growing toward the cash value.
How much can I borrow against my life insurance policy?
Most carriers allow loans up to 90% to 95% of the policy's cash surrender value. The exact limit varies by carrier and policy type. Borrowing close to the maximum creates lapse risk if interest accrues and the total loan balance approaches the full cash value.
What is the interest rate on a policy loan?
Policy loan interest rates are specified in the policy contract — typically ranging from 5% to 8% per year for older policies and variable rates for newer ones. Some whole life policies use a direct recognition approach where the dividend crediting rate on loaned amounts is adjusted; others use non-direct recognition where dividends are credited the same on loaned and unloaned amounts.
What happens if I don't repay my policy loan?
If the loan is never repaid, the outstanding balance plus accrued interest is deducted from the death benefit when the insured dies. If accrued interest causes the loan balance to exceed the cash value before death, the policy lapses — and the outstanding balance becomes a taxable distribution in the year of lapse to the extent it exceeds the policy's cost basis.
UNDERSTAND HOW TO ACCESS YOUR CASH VALUE WITHOUT UNEXPECTED CONSEQUENCES.
Kelly Insurance Group helps policyholders understand the difference between policy loans and withdrawals — and how to access permanent life insurance cash value in a way that preserves the death benefit and avoids unintended tax consequences.
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