What Happens When You Tap Your Policy?
Life‑insurance companies allow two primary ways to access cash from a whole or universal policy: a loan or a withdrawal. A loan borrows against the policy's cash value and accrues interest, while a withdrawal simply removes cash, reducing the policy's value permanently. Both methods lower the death benefit and affect the policy's growth, but they differ in cost, tax treatment, and long‑term impact.
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Loan Basics
How It Works
A policy loan is an interest‑only loan that can be repaid at any time. The loan amount is deducted from the cash value and, if unpaid, from the death benefit. The policy remains in force as long as the loan balance plus interest does not exceed the cash value.
Pros and Cons
- Pros: Interest rates are usually fixed and lower than consumer loans; repayment is flexible; the loan does not trigger a taxable event.
- Cons: Accruing interest reduces the policy's cash value; unpaid loans reduce the death benefit; if the policy lapses, the loan becomes a taxable debt.
Withdrawal Basics
How It Works
A withdrawal removes a portion of the policy's cash value outright. The amount withdrawn reduces both the cash value and the death benefit permanently. Withdrawals are not taxed until they exceed the policy's cost basis.
Pros and Cons
- Pros: Immediate cash; no repayment required; no interest accrues.
- Cons: Permanently reduces the death benefit; reduces future growth; can trigger taxes if the withdrawal exceeds the policy's cost basis.
Comparing the Two: A Quick Table
| Attribute | Loan | Withdrawal |
|---|---|---|
| Tax Treatment | Non‑taxable until repayment or lapse | Taxable if exceeds cost basis |
| Impact on Death Benefit | Reduced if not repaid | Permanent reduction |
| Interest | Accrued, typically low | None |
| Repayment Flexibility | Anytime, no penalty | No repayment |
When to Choose a Loan
If you need a sizable amount and want to keep the death benefit intact for later repayment, a loan can be a better option. Loans are also useful when you anticipate having sufficient income to pay back the debt and want to avoid a permanent loss of coverage.
When to Opt for a Withdrawal
Withdrawals suit short‑term cash needs or when the policy's cash value is low and a loan would jeopardize the policy's viability. They are also appropriate if you are comfortable accepting a permanent reduction in death benefit for immediate liquidity.
Long‑Term Considerations
Both choices erode the policy's growth potential. A loan that remains unpaid for years can significantly diminish the policy's value due to compounded interest. Withdrawals cut growth permanently. Regularly reviewing the policy's cash value, death benefit, and overall financial plan helps determine the best strategy over time.