When we review existing life insurance policies for the clients of our RIAs, we find that certain plans are failing and at risk of lapsing prematurely. There are generally 3 main causes for this:
Reason 1: Loans and withdrawals taken against the policy.
Reason 2: The premiums were not paid as they were supposed to be.
Reason 3: Assumptions that were made when the policy was sold were too optimistic.
In this article, we will explore loans and withdrawals.
Loans and withdrawals are attractive selling features for life insurance because the premiums paid into a policy grow tax-deferred over time and the policyholder does not pay taxes while the policy accumulates wealth, similar to a 401(k). That money is accessible through either loans or withdrawals without paying tax on the amount taken out. Because of this feature, many view these policies as cash accumulation vehicles, putting money into them with the intent of funding college educations, or even supplementing retirement plans. Unfortunately, many insurance agents fail to explain that there can also be negative consequences associated with using policies for this purpose.
Problem: Taking money out of a policy may permanently reduce its cash value, and the death benefit. And if funds are withdrawn too early in the policy, it may trigger a taxable event.
Problem: Loans accrue interest over time, so the outstanding loan amount gets significantly larger if it is not promptly paid back. Also, if a policyholder takes out a large loan and the policy lapses, or if the policy is surrendered or the policyholder dies, the outstanding loan becomes taxable as ordinary income, which can impart a tax burden.
If a client is considering taking money out of a life insurance policy, you will first need to find out whether a withdrawal or a loan is the most prudent course of action.
A policyholder who has decided to take a loan should consider increasing his or her premiums: The increase in premiums can be used to structure a loan pay off. Doing so will better sustain the death benefit and cash value. For example, if a given policyholder has taken a $10,000 loan and wishes to pay it off over 2 years, an increase in premiums of $500 a month can help prevent the loan from eroding the value of the policy.
Before your client decides whether to take a withdrawal or a loan on a policy, you will want to request an “in force illustration.” That will show hypothetically what the impact will be to the policy long term, and that will offer an insight into whether or not it will create serious problems down the road. You should also be sure to consult a qualified insurance expert to discuss the impact of taking money out of a policy before doing so.