Vol 11 No 8		August 2009

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Policy Loans and Withdrawals

"Cash value (permanent) policies generate cash values that can be used for unexpected bridge borrowing, long-term funding and to assist with retirement income. Whether money from policies is treated as a loan or withdrawal can produce significant differences in long term policy values. Which is better depends on how long the money is needed. . .The tool to confirm the advantage of using loans or withdrawals is policy illustrations. They should be obtained anytime every time loans or withdrawals are considered."

Managing life insurance policies with or acquiring loans is a challenge compared with policies with no indebtedness. The only way to see policy affects clearly is to obtain various illustrations showing future policy values in the presence of loans or cash withdrawals. Generalizing is difficult because companies and policies within companies can have different ways of dealing with policy loans and withdrawals that can't be intuitively inferred. This is why getting the illustrations is important.

Policy loans versus withdrawals will have a different impact on the policy at various times in the future. One absolute rule to follow is that withdrawals should be avoided if it will create taxable income. Taxable income occurs when more then the cost basis is withdrawn, or the policy is a modified endowment contract.

Let's review various issues.

Universal Life

Jim 65 has a conventional $1,000,000 UL (i.e., not a no-lapse) taken out 10 years ago. It has a cash value of $200,000. Jim needs $50,000 for a retirement home he is building. If he intends to repay the $50,000 it should be a loan. If Jim does not intend to repay, it should be a withdrawal. Generally cash values and death benefits in the medium- and long-term will be lower if a loan is taken. This is why taking a withdrawal is generally favored when it isn't going to be repaid. If a withdrawal is taken Jim might want to increase the death benefit by $50,000 before the withdrawal so the original death benefit will remain at $1,000,000. This isn't necessary for a loan that will be repaid because the death benefit generally goes up by the amount of the loan, returning to $1,000,000. The advantage of either a loan or withdrawal can be verified by obtaining various illustrations prior to making the transaction.

Long-term unpaid UL loans is one of the most common mistakes I see in my practice. It is easily corrected. After confirming the advantage of treating the loan as a withdrawal via illustrations, the loan is changed to a withdrawal. This corrects the mistake.

If Tom had instead purchased a no-lapse UL he would have less flexibility taking a loan or withdrawal because cash values are quite low relative to premiums paid and can adversely affect the policies guarantees. The ability to take loans and withdrawals is a significant drawback of no-lapse UL.

Some financial advisors sell conventional UL for the purpose of using cash values for retirement income. Tax-free withdrawals can be taken until they exceed the policy's cost basis and then loans can be taken. Loans are not taxable. However, policyowers need to be careful about taking too much from the policy that would cause it to terminate because cumulative taxes are immediately due upon termination. A huge tax with no cash to pay it can be an enormous problem. This can happen when astute attention isn't paid to a UL's interest crediting and cost of insurance in the long-run.

Variable Universal Life

My comments regarding policy loans and withdrawals for UL apply to VUL with one very large caveat. Policyowners should be wary of every aspect VUL, and that includes loans and withdrawals, because of the great liquidity problems when large investment losses are taken. The problem is so great that avoiding policy loans and withdrawals while VUL investments remain in equity sub-accounts is probably wise.

Whole Life

Whole life policy loans and withdrawals have similar characteristics as with UL. Generally, loans will work better if the policyowner intends to repay it, but withdrawals work better if it is not to be repaid. One complication with whole life that doesn't apply to UL is when withdrawals are taken the death benefit drops more than the amount of the withdrawal. A withdrawal of say $10,000 could result in a drop in the death benefit of $13,000. But in the long run a withdrawal has a positive affect on policy values compared with a loan, but not in the short run.

As with UL it is very common in my practice to see whole life policies with long-term loans that aren't going to be repaid that should be changed to withdrawals. This can substantially improve the long-term values of the policy.

An interesting strategy for clients that have contributed as much as possible to tax qualified plans and education funding such as 529 plans, and have investable funds available, is to super-fund a whole life policy, coordinated with their life insurance needs. This allows the whole life policy to generate maximum cash value for retirement funding. In retirement, withdrawals not loans can be taken tax-free until they equal the policy's cost basis for retirement. The policy's residual death benefits can then be used as an inheritance - freeing up other assets to be used in retirement.

Conclusion

Cash value (permanent) policies generate cash values that can be used for unexpected bridge borrowing, long-term funding and to assist with retirement income. Whether money from policies is treated as a loan or withdrawal can produce significant differences in long term policy values. Which is better depends on how long the money is needed. Short term needs usually favors taking loans. Long-term needs usually favors using withdrawals. A common problem is policies that have long-term loans that have been essentially forgotten. This error can be easily corrected. The tool to confirm the advantage of using loans or withdrawals is policy illustrations. They should be obtained anytime every time loans or withdrawals are considered.