Differences between Loans and Withdrawals

Index universal life insurance policies have to ability to build cash value accumulation that can be accessed income-tax-free for future needs. There are two ways to take your money out of an IUL.  By loan or withdrawal. It’s crucial to understand how each strategy works.

How Withdrawals Work

Withdrawals allow you can access cash value tax-free from your index universal life policy up to your basis. You can withdraw up to your cost basis (which is the total premiums you paid into the policy) income tax-free. After you have withdrawn to your basis any money taken out above your cost basis from the cash value account must be taken out as loans in order to access the cash income tax-free.

How Loans Work

There are two types of loans.

  • Fixed interest loans
  • Participating loans.

By borrowing against the policy’s cash value, you can access funds from your IUL plan tax-free. That is because the IRS does not consider loans to be taxable income. In addition, even though the insurance company will charge you interest on the un-repaid balance of the loan, you don’t necessarily have to pay it back. Most carriers also offer fixed-interest loans that can interest-free loans depending on the carrier’s fixed loan rate vs credit applied.

Loan Repayments

Loans don’t have to be repaid in an IUL that is because, upon your death, the funds from the policy’s death benefit can be used for repaying your tax-free loan. (And the remainder of the death benefit will then be paid to your beneficiary, also income tax-free).

An additional benefit when borrowing money from an IUL (as versus directly withdrawing it) is that the funds in the policy’s cash account will continue earning interest as if they had never been accessed.

Why is that?

​Because when you take a loan from your IUL plan, you are actually taking a loan from the insurance company – not your policy’s cash value. For example, if you have $100,000 in the cash component of an IUL, and you borrow $20,000 (technically leaving $80,000 in the account) interest will continue to be credited as if there were still $100,000.

Wealthy investors have been using this strategy for many years to help them with growing, protecting, and accessing their money in a tax-advantaged manner, and in turn, giving them much more control. Going this route can reduce – or even eliminate – the need to borrow from banks or other lenders and pay hefty interest payments on those borrowed funds.

Not all indexed universal life insurance policies – and in turn, not all IULs – are exactly the same with regard to how their loans work, though. So, it is essential that you work with an advisor who is well-versed in how these types of plans work, and who can advise you on whether or not this is the right strategy for you.

Understanding Participating Loans

Participating or non-participating loans (fixed interest loans) are oftentimes available in IUL policies. With a non-participating loan, the insurance carrier will essentially place a “lien” on the cash value in the amount of the loan. It will then place that cash in a “collateral” account.

The cash that is in the collateral account will generally earn a fixed interest rate, and the loan would be charged a different rate of interest (which could be either a fixed or a variable rate). At the same time, the remainder of the cash in the cash value account would continue earning the interest rate that it would normally earn.

However, with a participating loan, the collateral account does not exist. Also, the interest rate on the loan is dependent on the index of choice. The key difference here is that with a participating loan strategy, the cash that would act as the collateral would continue earning interest in the same manner as the rest of the policy’s cash value.

There are opportunities and trade-offs with each loan type.