One of the key benefits to owning an indexed universal life insurance policy is the ability to access funds from your policy’s cash value without having to pay tax. This same benefit can also allow you to use as much as 100% of the cash value your policy has accumulated.
There are several types of loans that are available with an IUL policy. These include:
With a fixed loan, you can borrow funds against your IUL policy, and the insurance company will charge a set interest rate on the amount that you’ve borrowed. For each dollar that you have borrowed, the insurance carrier will put the same amount of policy cash value into a “collateral” account. The insurance company will then guarantee that this collateral account will earn some rate of return.
If you take an indexed loan, the dollars that have been borrowed will continue to track the underlying index(es), rather than being allocated to a collateral account. The collateral against your loan will still be subject to the movement of the underlying index(es). In most cases, the interest rate that is charged by the insurance company on an indexed loan will be more than the interest that is charged on a fixed loan.
A variable loan will have some similarities to an indexed loan, whereby the borrowed funds will still track the underlying index(es). However, the interest rate that is charged by the insurer on a variable loan can frequently be lower than that of an indexed loan, because the insurance company is not held to a guaranteed rate. These loans can, however, charge a higher rate of interest than a fixed loan, as the collateral is typically in a vehicle that is riskier than cash.
Factors to Consider When Taking a Loan from an IUL Policy
It is important to note that IUL policy loans and withdrawals will reduce the available cash value and death benefits. These same events could also cause the policy to lapse, which could also cause all previous loans and withdrawals to be considered as taxable income, or affect guarantees on the to policy lapse. Also, additional premium payments may be required to keep the policy in force. In the event of a lapse, outstanding policy loans that are more than unrecovered cost could be subject to ordinary income tax.
In the event of a lapsed policy, loans are not typically classified as income tax; however, withdrawals or partial Surrenders are subject to income tax. If taken before age 59 ½, a 10% federal tax (“early withdrawal”) penalty may apply.