Dissecting Forbes article regarding Life Insurance Policy Loan Dangers
- David H. Kinder, RFC®, ChFC®, CLU®
- Nov 20, 2023
- 8 min read
Let me first start by stating that it is not my intention to create rebuttal articles to everything written and found on the internet. Unless someone wants to pay me a considerable sum... frankly, it's not the best use of my time. However, I will my thoughts on this particular article.
Here is the original article link: https://www.forbes.com/advisor/life-insurance/dangers-of-policy-loans/ The first thing I do when I see an article like this, is find out more about who wrote it. What may be their bias based on their experience and credentials? Is this someone with an axe to grind? Is this someone who just wants to create articles and publicity for themselves? Are they PAYING for the privilege to have a Forbes article? This article is written by Tony Steuer. I have never heard of him before, but I'm sure I've read a couple of his articles in the past. His about section states this: Tony Steuer, CLU, LA, CPFFE is an internationally recognized financial wellness advocate, award winning author, top ranked podcaster, speaker and Chief Education Officer at Females and Finance. Tony’s mission is to change the way we think about money.
When I see letters after one's name, I ask what are they and have I heard of them? Like myself, Tony is a CLU graduate and holder. This is the most advanced designation available for life insurance specialists. However, as a CLU graduate and holder myself, I know it could go deeper. I've never heard of an "LA" designation. I've searched, but I can't find it. It could simple mean "Life Agent", but with the other letters after his name, I'll just assume that it does mean something more than that, but I can't find it. The CPFFE is a designation that stands for Certified Personal Family & Finance Educator. I never heard of that one before until now. To me, as long as there is at least ONE well regarded designation after one's name (in this case, CLU), the others are simply supplementary to that credibility. I also looked up his website and his licensing based on his address. In California, he is a Life and Disability Analyst. This is a unique license (in addition to his other licensing) that allows the holder to represent the client for a fee to analyze their life and disability insurance policies. Bottom line: He's not an idiot and he's certainly not 'against' life insurance. However, he has a few errors that really should be cleared up in his article. The italicized text is from the original article. I will break it up by sections. My response will be in my standard font.
What Is a Life Insurance Policy Loan?
Policy loans are available on most permanent cash value life insurance policies. Life insurance policy loans are not the same as other loans: Policy owners are not required to repay the loan. Keep in mind, the insurance company will charge interest on the policy loan.
This is true. Policy loans are not like other conventional loans. They are very much 'unstructured' loans. You pay interest in arrears (which means up front) and it is paid out of your policy's remaining values. Each year, you can either pay the interest... or not. However... what are the consequences for NOT paying the interest every year? The loan interest continues to compound against the policy. This needs to be managed and monitored. Depending on the size of the loan against the policy, you may end up lapsing the policy should the loan balance become greater than the cash values.
If you borrow money from your life insurance policy, you are borrowing your own money. It is essentially an advance of money that could be received from the policy either through a surrender of the policy or the payment of the death benefit. It is money that you, or your beneficiary, would have received anyway. The policy’s cash value acts as collateral for the policy loan.
That first sentence is a false statement. You are NOT "borrowing your own money". You are NEVER "borrowing your own money". You are borrowing the insurance company's money secured by the cash values in YOUR policy. They are secured by the cash values while you are alive and then repaid back by the policy's death benefit when you pass. The rest of that paragraph is true. it is an advance of money that you could otherwise receive. The last line is absolutely true. I wish he would have led the paragraph with that instead of "borrowing your own money" line.
If you never pay back the policy loan during your lifetime, the amount is deducted from the death benefit when you pass away—meaning that your beneficiaries will receive less and essentially repay the loan.
In Board of Assessors v. New York Life Insurance Company (1910), U.S. Supreme Court Justice Oliver Wendell Holmes wrote, “The so-called liability of the policyholder never exists as a personal liability, it is never a debt, but is merely a deduction in account from the sum the plaintiffs (the insurer) ultimately must pay.”
No disagreements here. Good source material too. I'm going to skip to the parts of the article that may have some issues. I'll insert my commentary in [Bold].
Why Is a Life Insurance Policy Loan Risky?
An in-force policy illustration can help you determine how long your policy will remain in force while the loan is out. You will find that the larger the loan, the more impact it will have on your policy. [absolutely true]
For example, with an initial policy loan of $50,000 and a loan interest rate of 8%:
The loan interest in year one will be $4,000.
If you borrow the loan interest, your loan balance would increase to $54,000 (initial loan amount of $50,000 plus the loan interest of $4,000).
The loan interest in year two would increase to $4,320.
The loan balance would increase to $58,320 if the loan interest is borrowed again ($54,000 loan balance plus the loan interest of $4,320).
[This is a great example of the math, but while the article was written back in May 2023, most companies don't have that high of an interest rate. Even as I'm writing this, most companies are between 5 - 5.75% in a higher inflationary period.]
As you can see, this rapidly increases the policy loan balance.
Here’s how it works:
With a typical permanent life insurance policy, the cash value increases every year. This reduces the total risk to the insurer because it will pay out only the death benefit when you pass away and absorb the cash value. Mortality costs—the actual cost of insurance for you—are also increasing each year because you get older.
[That is not necessarily true. I'll give the author credit that he stated 'a typical permanent life insurance policy'. With a lifetime pay whole life policy, the mortality costs are built-in to the fixed premiums. With a lifetime pay Universal Life policy (UL, IUL, VUL, etc), they are 'unbundled' and functions much like an annual term policy that increases each and every year... however, that amount is only on the net amount at risk. (Net amount at risk is the difference between the net death benefit and the cash values of the policy.)
But the ongoing increase of TYPICAL permanent policies... is why I prefer limited pay whole life insurance. They STOP having that as an ongoing expense to the policy. In essence, that ongoing liability is now on the balance sheet of the insurance company, NOT the policyholder. (Sorry, but I nerded out on that one.] But that increase is usually offset for the insurer by the decreasing amount at risk.
If you’ve taken out a loan from the cash value, the lower cash value will result in lower earnings. [Not necessarily so. If the policy is considered a 'direct-recognition' policy, that would be true. Direct recognition means that the company will 'recognize' the loan against your cash values and adjust your dividends accordingly. A non-direct recognition policy will not. I generally prefer non-direct recognition.] If your premium payments aren’t enough to cover the mortality cost and other fees, the insurer will take it from your cash value. Now your cash value is being depleted by multiple demands—the loan, lower earnings and fees. And if the cash value goes to zero the policy will terminate, unless you make an infusion of premium.
If the policy terminates, you’ll get dinged by an income tax bill on the loan money you took. [No, that's not correct. You will get a tax bill based on the gains above your basis. What he's referring to is Phantom Income Tax. If a policy terminates, the gains in the policy above your cost basis is taxable as ordinary income. However, if you have loans against it, the loans are repaid first. You may not HAVE the money from the proceeds of the lapsed policy to pay the taxes! This is why it's considered a 'phantom income tax' because you had a gain, but you don't have the proceeds to pay it.]
Now, he does clarify this in his next section of his article, but he wasn't quite so clear with his terminology earlier.
Calculating Taxable Income from a Life Insurance Policy Loan [From a lapsed policy]
Here’s how to calculate the potential gain in the policy that would be subject to income tax:
Add the net cash (surrender) value, any dividends received (either prior or accumulated) and the outstanding loan balance.
Subtract the cost basis (sum of premiums paid into the policy).
Example: If a life insurance policy terminates with a loan balance of $100,000 and a cost basis of $50,000, the taxable gain would be $50,000. [In the event of a lapse, that is what will happen in that taxable year.]
Please note that the above example is a general rule and may not apply to every situation. You should consult your tax advisor to confirm whether you have a taxable gain.
Your life insurance company will be able to provide you with the cost basis, along with the gain that they will report to the Internal Revenue Service as 1099 income.
While a life insurance policy loan can provide you with immediate funds, it can have a number of drawbacks. Know what you’re getting into before you take the cash.
As you can tell, he's not a dummy and he's certainly not against one using their policy. He is advocating that one know what they're getting into before taking a loan. I also believe this. Many agents who promote "infinite banking" concepts often use a policy chassis or structure that requires a 'lifetime pay' on the policy. I understand why they do that, however, I prefer a limited pay policy. Have the policy STOP having costs of insurance that are incurred by the policyowner. One less cost to worry about. Also, when discussing using these policies for retirement cash flow, we aren't taking large lump-sums out at a given time. We're structuring a series of loan amounts. We need to consider the VOLUME of policy values compared to the volume of policy loans against those values.
For example: Let's say you have a $1 million cash value policy that is paid up (no more payments or premiums due and costs of insurance are now on the books of the insurance company, not the insured). Let's say you want to do loans for $50,000 per year for your retirement cash flow.
$1 million will earn what it earns. The $50,000 loan will have its cost. $1 million earning 5% (as an example) will see a credit of $50,000 to the policy.
The $50,000 loan may have a 5% interest cost or $2,500.
The $50,000 gain will be reduced by the $2,500, but you still have a far larger gain. (We'll keep the loan interest being paid by the policy.)
But what about year 2? In year 2, we have $1,050,000 still earning 5% (as an example) for $52,500. We do another loan of $50,000 at 5% for $2,500. The loan interest on the first loan grows to $2,625 of interest + $2,500 = $5,125 of loan interest. $52,500 - $5,125 = $47,375 NET GAIN (A pretty good deal for tax-exempt cash flow.)
We do our cash flow projections based on life expectancy plus five years.
Bottom line: We LOVE it that our clients do their own research and find (generally) very well written articles to help them ask good questions about the decisions they are looking to implement. This one was a bit tricky, but I'm glad to give a bit of clarity on the topic.
A quick note to add: One of my blog readers and colleague, who also holds CLU and ChFC designations, sent me this regarding the source article: "If the loan is taken out in the middle of a policy year, interest is charged for the remainder of the policy year at the time the loan is taken out. If a loan repayment is made during the policy year, the insurance company will typically not provide any credit or refund on the interest paid in advance.
100% untrue
If you take out a loan and pay it back in full 6 months later the insurance company refunds the last 6 months of interest." Thank you Jeff!
