Unpaid interest can create trouble
If you pay your loan interest out of your pocket, you have little to fear. But if you instruct your insurer to pay your loan interest with dividends or by dipping into your policy, you could be headed for serious trouble. That's because if they fail to cover the full interest due, that unpaid interest will accrue as income and be added to the loan balance.
"One client with a policy cash value of $1 million borrowed $900,000 and let $900,000 worth of interest compound for 10 years, using dividends or loans to pay the interest. She called and said, 'I just got a 1099 from the IRS for $1.6 million!'" Barnes says.
Although it was what the Internal Revenue Service calls "phantom" income, meaning there was no corresponding cash flow, she was still on the hook for years of borrowing from her own policy.
The kicker is you may not discover how far in the hole your policy has fallen until you opt to drop it or your insurer notifies you that it's about to lapse, both of which constitute a taxable event that can prompt that heart-stopping IRS notice of tax due. And once you owe more than the amount you borrowed, you can't simply pay your way back into the black; you have to pay the whole loan back.
Wetmore says consumers should not venture into policy loan territory without a firm understanding of the risks. You can ask your insurance agent to run what's called an "in-force illustration" that shows the impact a loan will have on your policy.
"If I were to take a loan on my policy, I'm probably going to monitor that annually," says Wetmore.