Indexed UL loan mistakes: rate, crediting and lapse traps

Borrowing from an indexed universal life policy is legal, common and, for a policy that stays in force, generally not taxed as income. It is also the point where several separate pieces of fine print meet: the loan interest rate, the way borrowed money is credited, the limit on how much can be borrowed and the tax rule for a policy that ends with a loan outstanding. Most trouble comes from assuming those pieces fit together in a way that favors the owner. This post lists eight mistakes, why each one happens, and what to ask instead.

The post takes no side on whether IUL loans are a good retirement strategy. People who understand the mechanics use them deliberately, and people who do not sometimes lose a policy. The figures are invented round numbers for the arithmetic, not rates from any insurer.

First, how an IUL loan works

A policy loan is not a withdrawal. The insurer lends you its own money and keeps part of your cash value as collateral. The policy stays in force, the death benefit is reduced by the loan and unpaid interest, and you may repay on any schedule or not at all. The general mechanics are in life insurance policy loans: how they work and what they risk.

Three features are specific to indexed policies and drive most of the mistakes below.

1. The collateral usually moves. When you borrow, the insurer typically moves an equal amount of account value out of the index accounts into a loan account, where it is credited in a way set by the contract. The two common designs are a fixed (or "wash") loan, in which the loan account earns a stated rate close to the loan rate, and a participating (or variable) loan, in which the collateral remains in the index accounts and keeps earning index credits, at the cost of a loan rate that may be variable.
2. The loan charges interest every day. Whatever the credit design, interest accrues at the loan rate, and unpaid interest is added to the loan balance.
3. Monthly charges continue. The cost of insurance and other deductions still come out of the account value while the loan is outstanding.

Which design applies to you is in the contract's loan provisions. Ask for them in writing.

Mistake 1: Assuming the loan rate equals the credited rate

How it happens. A sales conversation says that the policy's loan is "free" or "zero-cost" because the loan rate and the credit on the borrowed money are the same. Sometimes this is nearly true, in a fixed-loan design where the loan account earns a rate close to the loan rate. Often it is not true in the long run: the loan rate is higher than the loan account's credit by a spread, or the credit and the loan rate are both variable and move differently.

What it costs. Say Tom borrows $100,000 at a 5% loan rate, and the loan account credits his collateral at 3%. Neither interest is paid. After 10 years:

• Loan balance: $100,000 × 1.05^10 = $162,889.46.
• Collateral at 3%: $100,000 × 1.03^10 = $134,391.64.
• Gap: $162,889.46 − $134,391.64 = $28,497.82.

The gap is the cost of the spread, about 2 percentage points a year, compounded. It also shows up as a smaller net cash value and, eventually, a smaller death benefit.

How to avoid it. Ask for the exact loan rate, whether it is fixed or variable, the rate credited on the collateral and the guaranteed minimum and maximum for each. Compute the spread, then compute what it costs over the years you plan to borrow.

Mistake 2: Ignoring how borrowed values are credited

How it happens. An illustration of retirement income through loans often assumes the policy keeps crediting at the illustrated index rate on the entire account value, including the part that is collateral. In a participating-loan design that assumption can be roughly right. In a fixed-loan design it is not: the collateral earns the loan account's stated rate, not the index credit.

What it costs. Say a policy earns an average of 6% in the illustration while the loan rate is 5%. If the collateral is in a participating design and credits come through, the borrower might expect to earn about 1 point more than the loan costs. But index credits arrive in lumps with zeros in between. In a year when the index account credits 0%, the borrower still pays 5% on the loan. On a $100,000 loan that is $5,000 of interest in a year in which the collateral earned nothing. Over a run of flat or down years the loan outpaces the account.

How to avoid it. Ask the insurer which design applies, then ask for an illustration of the loan at a steady 4% and at a path with zero-credit years. The blog post Stress-testing an IUL illustration with lower assumed rates shows how to lower the assumed rate, and cap, participation and spread on the same index path: a worksheet shows how uneven credits behave.

Mistake 3: Borrowing too much, too early

How it happens. The loan limit stated in the contract is often a high share of the cash surrender value, sometimes close to all of it. In the early years the cash surrender value is smaller than the account value because surrender charges apply, so the limit is lower. After the surrender period the limit rises. Some owners borrow to the limit and discover that interest consumes the margin.

What it costs. A policy with a loan near its limit has almost no room. Charges continue, interest compounds, and a few weak crediting years can push the loan above the cash value. When that happens the policy lapses.

How to avoid it. Borrow well below the limit, set a maximum loan-to-cash-value ratio you will not exceed (a fee-only planner can help you pick one), and review it every year using the policy loan statement. The policy loan calculator shows how a balance grows.

Mistake 4: Letting interest compound unpaid, then being surprised by the lapse

How it happens. Unpaid loan interest is added to the loan. The loan therefore grows at the loan rate, and the cash value grows at the credited rate, which may be lower. When the loan balance catches up with the cash surrender value, the account cannot cover the loan and the monthly charges, and the policy enters its grace period.

What it costs. The result is a lapse, with a tax consequence in the next mistake. Even without a lapse, the death benefit paid to beneficiaries is reduced by the loan and its interest. In Tom's example the loan after 10 years is $162,889, so a $500,000 death benefit would pay about $337,111 before other adjustments.

How to avoid it. Pay at least the interest each year, if you can. Ask the insurer for a projection of the loan balance against the cash surrender value to the age you plan to be covered, on current and on lower crediting assumptions. If the loan is expected to catch up with the cash value, look at overloan protection riders: how they prevent a taxable lapse; if one is attached, learn its trigger and its cost.

Mistake 5: Not knowing that a lapse with a loan can be taxable

How it happens. The rule that loans are not taxable income applies while the policy is in force. If the policy lapses or is surrendered with a loan outstanding, the loan is treated as an amount received, and the part above the policy's cost basis is generally taxable as ordinary income, even though the owner got no new cash.

What it costs. Say Tom paid $90,000 in total premiums over the years (his basis) and the policy lapses with the $162,889 loan outstanding. The gain is roughly the loan balance, plus any cash he received earlier, minus basis. Using only the loan: $162,889 − $90,000 = $72,889 of potential taxable income in the year of the lapse, with no cash from the lapse to pay the tax. A tax professional computes the actual amount, which depends on prior withdrawals and other details. The figure is invented here to show the size of the problem.

How to avoid it. Before the loan balance gets near the cash value, decide what you will do: repay, add premium, reduce the benefit or use the protective rider. A planned surrender is a different transaction from a lapse and is often easier to manage. See how cash value is taxed: withdrawals, loans and surrenders.

Mistake 6: Ignoring modified endowment contract status

How it happens. A policy funded faster than the seven-pay test allows becomes a modified endowment contracts and the 7-pay test. Loans from a modified endowment contract are taxed gains first and a 10% additional tax can apply before age 59½. Some owners overfund a policy, in the first seven years, to build cash for later loans without noticing the line.

What it costs. The tax-free loan that the plan depends on is not tax-free. The change is permanent for the policy.

How to avoid it. Ask the insurer to confirm in writing that the policy is not a modified endowment contract before taking any loan, and ask whether a death-benefit reduction or other change in the first seven years could have restarted the test.

Mistake 7: Stopping premiums while borrowing

How it happens. An owner uses loans for income and stops paying premiums on the assumption that the cash value covers the policy. But premiums, charges and loans pull in different directions. Loans take collateral out of the crediting engine, charges keep coming and the interest grows. If premiums stop and the account is also borrowed against, the net cash value shrinks faster than most illustrations suggest.

What it costs. The policy may reach the lapse point decades before the owner expects. The older the insured, the higher the cost of insurance, and the more the lapse risk grows in the late years.

How to avoid it. Ask for an in-force illustration that includes the loans you plan and shows premiums, charges and loan interest each year. If the policy is meant to last for life, make sure the illustration extends to age 100 or beyond and that the guaranteed column does not show an early lapse.

Mistake 8: Treating the illustration as a promise

How it happens. A proposal that shows steady loans in retirement is built on a steady illustrated rate. Real credits come in lumps, caps and spreads change, and the cost of insurance can rise. The regulator's limits on illustrated rates and loan leverage (described in the guide on Indexed universal life (IUL) explained) make the illustration more conservative, not predictive.

What it costs. An owner who plans around the illustrated numbers can run out of room when reality is below them. A shortfall found at 75 is harder to fix than one found at 60.

How to avoid it. Ask for the same loan schedule run at a lower rate and a rate path with flat years. Run it every few years. If the policy is also a retirement plan, the case for and against it is set out in the guides on using life insurance for retirement income.

If you already have a loan: repairing it

Most of the mistakes above are found after the fact. If you already have a loan, the repair options are fairly short, and each is better the earlier it is used.

1. Pay the interest. Even partial payments slow the compounding. Ask the insurer how to designate a payment as loan interest or principal; a premium payment sent without instruction can be applied to the premium instead.
2. Repay principal in lumps. A bonus, a sale or a required distribution from another account can reduce the loan. Repayment moves collateral back to the index accounts in most designs, after which it earns index credits again.
3. Reduce the death benefit. Lowering the face amount cuts the cost of insurance and leaves more of the account to carry the loan. Ask about surrender charges and the tax effect first.
4. Add premium. A modest, regular premium is easier on a policy than a large one at the last moment. Check modified endowment status before paying more.
5. Ask about overloan protection. If the policy has an overloan protection riders: how they prevent a taxable lapse, learn its trigger and conditions now. Riders of this kind commonly require a minimum policy age and insured age, and they work by converting the policy to paid-up status with a much smaller death benefit, after which no premiums are due and no further loans are allowed.
6. Plan the exit. If none of these works, a planned surrender or an exchange is better than an accidental lapse. The tax result depends on your basis, which only your statements and a tax professional can pin down.

A short checklist before you borrow

1. Is the policy in force and not a modified endowment contract? Get it in writing.
2. What is the loan rate, and is it fixed or variable?
3. How is the borrowed value credited, and what is the spread to the loan rate?
4. What is the contract's loan limit, and how much of it am I using?
5. Can I pay the interest each year? If not, what is the projected loan balance in 10 and 20 years?
6. What does the guaranteed column show with the loan?
7. What will I do if the loan nears the cash value, and is there an overloan protection rider on the policy?
8. Has a tax professional looked at my basis and the plan?

Key takeaways

• A loan rate and a credited rate are two different numbers. The gap between them, compounded, is the real cost of the loan; in the example a 2-point spread opened a gap of about $28,500 on $100,000 in 10 years.
• Find out whether your contract moves borrowed money to a fixed loan account or leaves it in the index accounts, because that changes what the money earns while it is borrowed.
• Unpaid interest compounds, and a loan that outgrows the cash value lapses the policy; a lapse can create taxable income without cash.
• Check modified endowment contract status, the guaranteed illustration column and the loan-to-cash-value ratio before borrowing, and again every year.
• Test the plan at lower rates and with flat years. A policy that works only on the illustrated path has no margin.