What happens to a life insurance policy loan when the policy lapses?
Key takeaway
When a life insurance policy with a loan lapses, the loan can produce taxable income. Practitioners describe a lapse of a policy with a loan as possibly causing taxable gain, and they describe policy loans as accruing interest and reducing the death benefit. Owners of businesses and private investments meet this point when a policy has built-up cash value.
How policy loans work
A policy with built-up cash value may give access to funds through withdrawals or, more commonly, through policy loans. Policy loan interest is generally added to the loan amount.
What practitioners describe when a policy lapses
Practitioners describe lapse of a whole life policy with a loan as possibly causing taxable gain if the loan exceeds the premiums paid.
Practitioners say letting a life insurance policy lapse because premiums went unpaid can have adverse tax consequences. For financed policies secured by cash value, taxable gain is described as roughly the total cash value minus the aggregate premium payments.
Policy loans may cause taxable income if the policy lapses or is surrendered with gain.
Lapse is not the only outcome
Estate planning practitioners describe options other than lapse, including surrender for cash value or conversion to reduced paid-up insurance.
A no lapse feature is described as fixing the death benefit at a certain amount as long as minimum payments are made. Missing one payment loses that feature, and loan lapse riders work in a different way.
