Implications of Withdrawals and Loans from a Life Insurance Policy

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1 Implications of Withdrawals and Loans from a Life Insurance Policy Life insurance is frequently structured to provide income that can be used for various needs, such as supplemental retirement income, college funding, debt reduction and emergencies or other unexpected events. In its earliest modern-day form, life insurance was truly a death benefit-oriented product designed to provide financial stability and replace income for families who had lost a primary breadwinner due to an untimely death. Today the death benefit protection aspect of a life insurance policy is still its primary use; however, life insurance companies have created multiple variations of the standard life insurance policy to fit the evolving needs of consumers. Life insurance is now a very flexible product, frequently used as a cash accumulation or investment vehicle due to how it is currently taxed. One current tax benefit that life insurance provides is an income-tax-free death benefit that is paid out to beneficiaries at the insured s death. However, life insurance also offers tax advantages to the policy owner while they are living. Any earnings or cash accumulation within the policy is accumulated on a tax-deferred basis, and in some cases these earnings can be accessed by the policy owner income-tax-free. (For more information on tax treatment of life insurance policies, see Internal Revenue Code (IRC) Section 72(e)(1), Section 72(e)(5)(C) and Section 101(a)(1).) For this reason, life insurance is frequently structured to provide income that can be used for various needs, such as supplemental retirement income, college funding, debt reduction and emergencies or other unexpected events. Many financial advisors and life insurance professionals advise their clients to implement this design in their financial planning because they understand the financial advantages of utilizing life insurance versus other cash accumulation vehicles that are subject to taxation (e.g., individual retirement accounts, stocks, etc.). However, when advising clients to utilize life insurance as a cash accumulation or investment vehicle, it is important to understand the implications of accessing the policy s cash value and how this may differ among different product types. Withdrawals and Loans When permitted by the terms of the life insurance contract, there are two primary ways in which the cash value accumulated within a life insurance policy is generally accessed without completely surrendering the policy: withdrawals and loans. What Is a Withdrawal from a Life Insurance Policy? A withdrawal is a cash distribution that can be taken out of the policy tax-free up to the policy s cost basis (generally total premiums paid), assuming the policy is not classified as a modified endowment contract (MEC). It is important to note that withdrawals could potentially reduce the death benefit. In cash accumulating life insurance policies, the cash value also represents part of the death benefit; therefore, if the withdrawal reduces the cash value, there could also be a reduction in the death benefit. Additionally, if the death benefit is reduced, the withdrawals could be subject to taxation. This would occur if a withdrawal were taken during the first 15 years of the policy and caused a reduction in the policy s death benefit. In this case, some or all of the withdrawn cash could be considered taxable income. After 15 policy years, withdrawals up to policy basis are not taxable, assuming the White Paper continues >

2 Page 2 of 6 White Paper policy is not classified as a MEC. (For more information on the definition of life insurance and the treatment of distributions from a life insurance policy, see IRC Sections 7702 and 7702A.) What Is a Loan from a Life Insurance Policy? A loan is proceeds borrowed from a life insurance policy up to the amount of the cash surrender value (the cash accumulation value minus surrender charges) and based on the contract terms. The money is not actually being taken out of the policy; instead it is a loan taken against the policy s cash accumulation value. The cash accumulation value secures the loan; therefore, there must be sufficient funds in the policy to secure the loan. Unlike most loans, these are not accompanied by a schedule for repayment, and repayment is not required. A loan against a life insurance policy accrues interest that will continue to accrue as long as the loan is unpaid and reduces the cash value and death benefit. There is an interest rate that is charged and a crediting rate that is credited. The difference between the two is called the loan spread. The loan spread is the actual interest rate that is charged to the loan. Many contracts offer preferred loans that, at a certain point in the contract (e.g., years 11+), provide a lower loan spread, in many cases a 0 percent loan spread. Interest rates vary widely for these loans and additional fees may be added during the borrowing process that will add to this baseline rate. A loan, if not repaid earlier, is eventually repaid from policy proceeds at death, surrender or lapse. If the policy loan is still outstanding when the policy is surrendered, or if the policy lapses, the amount of the loan (including interest due) will be considered taxable income to the extent that there is gain in the policy. A gain is any amount of money in excess of the total premiums paid into the policy. Types of Loans Fixed Loans Fixed loans, also commonly referred to as traditional loans, have a fixed loan interest rate charge and a fixed crediting rate that is declared by the life insurance company. Most cash accumulating life insurance products offer fixed loans. Variable Loans Variable loans, also commonly referred to as participating loans or index loans, have a variable loan interest rate that fluctuates. Variable loans are not as widely available as fixed loans and are mostly available with indexed universal life products and participating whole life products. Many insurance companies that offer variable loans tie their charged interest rate to the Moody s Corporate Bond Yield Average or other well-recognized bond indexes; others have a set or declared rate but reserve the right to change that charged rate at their discretion. In both cases, there is typically a maximum loan interest rate declared by the insurance company and outlined in the policy. A major disadvantage of a variable loan is the uncertainty and additional volatility it adds to the life insurance policy. Both the policy s crediting rate and the loan interest rate can change and significantly deviate from what is originally projected, meaning that the total net cost of the loan is unpredictable. And, although there is the possibility of positive arbitrage if the credited earnings outperform loan interest being charged, there is also What is a MEC? A MEC is a type of life insurance product with unfavorable tax consequences. A life insurance policy becomes a MEC if the cumulative premium payments applicable to the policy s Seven-Pay Test period exceed, at any time during the Seven-Pay Test period, the cumulative total of the Seven-Pay premiums in that period. The Seven-Pay Test period starts when a policy is issued and runs for seven years, but it will start over and run for seven more years if there is a material change in the terms or benefits of the policy. Each time a material change occurs, the policy will start a new Seven-Pay Test period. For the purposes of the Seven-Pay Test rules, a material change will generally occur if there is both: 1) an increase in policy benefits; and 2) a premium payment not necessary to fund the policy benefits assumed in the most recent Seven-Pay Premium determination. The increase and the premium payment can occur separately and in either order. A material change may also occur as a result of certain other policy changes. Generally, once a policy is a MEC, it is always a MEC. Even if the MEC policy is exchanged for a new policy, the new policy will be a MEC. This test was implemented to prevent policyholders from paying large amounts (or a single premium) in early policy years and then borrowing the cash value tax-free. Although MEC contracts qualify as life insurance, and death benefits are still generally received income-taxfree, the owner may lose some of the advantages of tax-deferred growth, and loans and withdrawals can incur penalties. Distributions from a MEC are taxed differently than distributions from non-mec policies. Distributions are taxed as ordinary income when received to the extent that there is a gain in the contract; therefore, distributions from a MEC contract are taxed as income first and recovery of basis second until all gain has been withdrawn or borrowed. Additionally, unless the taxpayer is at least 59½ years old, has become disabled or the distribution is part of a series of substantially equal periodic payments over the life expectancy of the taxpayer or the taxpayer and his beneficiary, any taxable distribution from a MEC will be subject to a 10 percent early withdrawal penalty. Even if a policy would become a MEC because of the payment of premiums in excess of the cumulative MEC premium, MEC status can still be avoided if the insurer returns the excess premium paid plus interest within 60 days of the end of the year in which the excess occurs.

3 Page 3 of 6 White Paper the possibility that the loan rate charged could exceed the policy s crediting rate, creating a negative arbitrage and causing the client to be upside-down in their life insurance policy. Regardless of what loan option a client elects, they need to be educated on all of the implications of a loan in a life insurance policy, be shown various potential outcomes and expect to fund the policy in a suitable manner. Taking a Loan Once a loan is requested by the policyowner, if it is a fixed loan, the insurance company issues the loan and sets aside an equivalent amount of money into a fixed interest account. If the client has opted for a variable loan, the insurance company leaves the cash value in the policy so that policy values that are loaned against continue to earn the assumed crediting rate. This is an advantage of a variable loan. Most policies offer the option to switch from fixed to variable loans and vice versa, but insurance companies will each have certain guidelines and restrictions as far as frequency and timing. Additional Withdrawal and Loan Considerations Withdrawals or loans that reduce the cash surrender value could cause the premiums to increase in order to maintain the same death benefit and/or to keep the policy from lapsing. As mentioned before, if there is a loan taken from the policy and it is still outstanding when the policy lapses, the amount of the loan (including interest due) will be considered taxable income to the extent that there is gain in the policy. However, most policies that permit loans also offer an Overloan Protection Rider. This rider is designed to prevent the policyowner from borrowing too much from the policy, and protects them from incurring unwanted income taxes if the policy should lapse. It is also important to understand that withdrawals from the policy will permanently reduce the cash value, and if the withdrawal were also to cause a reduction in the death benefit, the death benefit available to the insured s beneficiaries will also be a permanently reduced. Additionally, any interest credited to the policy after a withdrawal has been taken will be credited based on a lesser cash value balance. In contrast, loans reduce the policy s cash value and death benefit until they are repaid and have a loan interest that is paid annually on the total loan balance. Therefore, the benefit payable to the insured s beneficiaries can be fully restored if the loan is repaid, but until that time, a lesser death benefit is available, and interest is earned only on the reduced or net cash value. One other aspect of a loan to consider is that when a life insurance policy with an outstanding policy loan is exchanged for another life insurance policy (e.g., IRC Section 1035 Exchange), the loan is considered boot and is subject to income taxation to the extent of any gain in the original policy. There are two potential solutions to avoid taxation in this situation: 1) transfer the loan as part of the exchange, which is still considered a valid 1035 exchange by the Internal Revenue Service (IRS) (see IRS Private Letter Rulings , and ) or 2) pay off the loan prior to the exchange. If the loan is paid off before the exchange utilizing cash value from the original life insurance policy, the IRS may apply the step transaction doctrine and consider the payment of the loan and the 1035 exchange as one transaction, and, as a result, the paid-off loan is treated as boot. A safer approach may be to pay the loan using funds from sources other than the original life insurance policy, such as the policyowners own out-of-pocket funds. It is also possible for the policyowner to take a withdrawal to basis from the life insurance policy to repay the loan. However, if this is done soon before the exchange, the IRS may also consider this a step transaction and attempt to treat the paid-off loan as boot. Rider A rider is a life insurance policy provision that is purchased separately from the base policy and that provides additional benefits at an additional cost. Boot In tax law, boot is the extra money, unrelated or non-like-kind property, or assumption of liabilities included in an otherwise like-kind nontaxable exchange of property. The boot is subject to income tax. Step Transaction Doctrine This is a judicial doctrine in the United States that combines a series of formally separate steps, resulting in tax treatment as a single integrated event. The doctrine is applied to prevent tax abuse, such as tax shelters or bailing assets out of a corporation. The doctrine states that interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction. By thus linking together all interdependent steps with legal or business significance, rather than taking them in isolation, federal tax liability may be based on a realistic view of the entire transaction. 1

4 Page 4 of 6 White Paper Withdrawal and Loan Availability There are certain restrictions as to when clients can take withdrawals and loans after a policy has been issued. Most insurance companies permit loans in policy year one, assuming there is sufficient cash value in the policy to take a loan, and withdrawals starting in policy year two. However, this varies among life insurance companies. For example, some companies permit withdrawals after the free-look period has expired and some do not permit loans until the beginning of policy year two. Free-look Period A period of time, generally around 10 days but varies by insurance company, during which a new insurance policyowner can terminate their life insurance contract without penalties such as surrender charges. This period of time allows the contract holder to decide whether or not they want to keep their policy, and if they are not satisfied, they can terminate the contract and receive a refund. When to Take a Withdrawal Versus a Loan Insurance agents generally advise clients who would like to access the cash accumulation in their policies to take withdrawals until the policy s cost basis has been exhausted. Once that threshold has been reached, they then recommend the client take loans against the policy s accumulated cash value. This strategy is utilized to avoid taxable consequences while still allowing the client to access their accumulated cash value. However, there are situations in which just taking loans will make sense for the client. If the client does not intend to repay the money borrowed from the contract, they should follow the withdrawals to basis, then loans strategy. If they do intend to repay, it could be more favorable for them to just take loans. The logic behind this reasoning is that there is no cost or charge to take a withdrawal, whereas with a loan there is an interest that is charged and that accrues as long as the loan remains unpaid. Therefore, if there is no intent to repay the borrowed funds, withdrawals will have less of an impact on the cash value accumulation in the long term when compared to loans, because there are no charges associated with withdrawals. However, with a withdrawal there is a permanent reduction in the cash value and potentially the death benefit. For that reason, if the client does intend to repay the borrowed funds, straight loans could be a better option because the cash value continues to earn interest, and once the repayment occurs, the death benefit can be restored. The advantage of either strategy for a client s particular situation should be verified by obtaining various illustrations demonstrating both options prior to making the transaction. Impact of Withdrawals and Loans on Guaranteed Death Benefit Products There are many life insurance products that offer a guaranteed death benefit either via the underlying structure of the product or a rider; these products are generally referred to as no-lapse guarantee products. Most no-lapse guarantee products are not designed to be cash accumulation products and are primarily death benefit focused. However, some newer, more creative versions of these products incorporate cash accumulation in the design, offering the client both death benefit guarantees and cash value flexibility. Although the availability of cash value is an attractive option within these products, accessing the cash value via withdrawals and loans can have an adverse effect on the policy guarantees, generally resulting in a reduced guarantee period and in some cases even a complete loss of the death benefit guarantee provision. (See Exhibit 1 and 2 on Page 5.) Most carriers offer catch-up provisions that would allow the insured to pay premiums (typically premiums plus interest) to get the policy back on track and restore the desired guarantee period; however, catch-up premiums can be very expensive. There is also the concern that the client and/or life insurance agent do not realize that the guarantees have been shortened until the cost to restore the desired length of guarantees is prohibitive. Therefore, it is imperative that clients thoroughly understand the impact that withdrawals and loans can have on their no-lapse guarantee policy before taking either from their policy.

5 Page 5 of 6 White Paper Exhibit 1: Based on $1 million guaranteed universal life policy that is guaranteed for life (age 121), for a male, age 55, with a preferred nonsmoker risk class. The cash surrender value in year 20 is $294,522. Scenario Withdrawal of $25,000 in Year 20 Withdrawal of $50,000 in Year 20 Withdrawal of $100,000 in Year 20 Guarantee Duration Guaranteed duration reduced to age 102 (reduced by 19 years) Guaranteed duration reduced to age 100 (reduced by 21 years) Guaranteed duration reduced to age 96 (reduced by 25 years) Exhibit 2: Based on $1 million variable universal life policy with a no-lapse guarantee rider that is guaranteed to age 90, for a male, age 55, with a preferred nonsmoker risk class. Assuming a 7 percent gross crediting rate, the cash surrender value in year 20 is $226,660. Scenario Withdrawal of $25,000 in Year 20 Withdrawal of $50,000 in Year 20 Withdrawal of $100,000 in Year 20 Guarantee Duration Death benefit guarantee rider is terminated. The death benefit was reduced to $975,000. On a non-guaranteed basis, this policy carries to age 91. Death benefit guarantee rider is terminated. The death benefit was reduced to $950,000. On a non-guaranteed basis, this policy carries to age 87. Death benefit guarantee rider is terminated. The death benefit was reduced to $900,000. On a non-guaranteed basis, this policy carries to age 79. Impact of Withdrawals and Loans on Indexed Universal Life Products With indexed universal life (IUL) products, the premium schedule is a key factor in determining cash value growth. When premiums are paid and allocated to an index account within an IUL, an investment segment period is created and the cash value growth is usually measured by using a point-to-point method, such as month-to-month, over a year or over multiple years. The growth of the particular index that is tied to the performance of the IUL (e.g., S&P 500) is measured on the segment beginning date (commonly referred to as the sweep date ) and again at the end of that segment (e.g., one year). The cash value growth is then calculated and credited to the policy. Each premium payment made by the client is handled by the insurance company as a separate segment period. Due to the unique crediting methodology of IUL products, the timing of withdrawals and loans is particularly important as it will impact the cash value growth of the policy. Variable loans generally do not impact the policy growth as much as a fixed loan or a withdrawal. There are charges associated with variable loans and interest that will accrue, both of which will impact the cash value growth; however, the policy values that are loaned against continue to earn the credited interest rate. Withdrawals and fixed loans will impact the cash value growth, and the timing of these is important because it will affect the earnings credited to the policy for the applicable segment period. When a withdrawal or loan is taken, most companies will only credit the policy the guaranteed interest for the partial period (i.e., segment duration prior to the loan or withdrawal). Effectively, the policy will only receive a partial credit on the amount of the deduction based on the amount of time the money was in the indexed account. With some policies, loans and withdrawals may also limit the policyowner s ability to transfer or allocate funds into the index account(s) for a certain period of time. Impact of Loans on Whole Life Products Whole life policies are generally one of two types: participating or non-participating. Participating whole life policies pay dividends, which are profits the company shares with the policyholders enabling them to participate in the insurance company s favorable experiences, such as higher than expected investment returns or lower than expected operation costs. However, it is important to note that dividends are not guaranteed. Non-participating policies generally offer all the same features as a participating whole life policy but do not pay dividends. Non-participating policies only offer fixed-rate loans. Participating products offer both fixed- and variable-rate loans, depending on which dividend recognition methodology the insurance company utilizes: direct recognition or non-direct recognition. Direct recognition policies offer fixed-rate loans, and the dividends earned on the policy are adjusted

6 Page 6 of 6 White Paper (generally reduced, but not always the case) based on the average loan outstanding during a given policy year. Simply put, there is a different dividend paid to loaned policy values versus non-loaned policy values. Non-direct recognition policies offer variable loans and do not adjust the dividends paid on a policy when there is an outstanding policy loan. The dividend rate is the same for loaned and non-loaned policy values. Since the dividend rate is the same, the cash value growth is not affected when a client takes a loan, because it continues to grow in the policy exactly as it would had the client not taken a loan. Summary Life insurance policies can be great cash accumulation or investment vehicles due to their current tax treatment. When structured and managed properly, a life insurance policy can provide a client with significant returns that in turn can help them supplement various future financial needs. However, it is imperative that clients who intend to use their life insurance policies for future income thoroughly understand the implications of accessing the policy s cash value and how it will affect their specific policy. Footnotes 1. Commissioner v. Clark, 489 U.S. 726, 738 (1989). This document describes fixed insurance. Any guarantees offered by life insurance products are subject to the claims-paying ability of the issuing insurance company. Riders may be available for an additional cost. There are considerable issues that need to be considered before replacing life insurance such as, but not limited to; commissions, fees, expenses, surrender charges, premiums, and new contestability period. There may also be unfavorable tax consequences caused by surrendering an existing policy, such as a potential tax on outstanding policy loans. Please discuss your situation with your financial advisor. This material was created by NFP (National Financial Partners Corp.), its subsidiaries, or affiliates for distribution by their representatives and/or agents. This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Neither NFP nor its subsidiaries or affiliates offer tax or legal advice /13 (INS ) Copyright 2013 NFP. All rights reserved.