The end result is that even though Sheila will only salvage $5,000 from the surrender of her life insurance policy, she’ll receive a Form 1099-R for the $45,000 gain, and at a 25% tax rate will owe $11,250 of income taxes… which is more than the entire net surrender value of the life insurance policy, due to the loan!
However, as illustrated in the recent case of Mallory v. Commissioner, the Tax Courts have long recognized that the gain on a life insurance policy is taxable, even if all the cash value itself is used to repay an existing policy loan!
The fact that the lapse of a life insurance policy with a loan can trigger tax consequences even if there is no (net) cash value remaining is often a surprise for policyowners, and has even created a number of Tax Court cases against the IRS over the years
An important caveat of the potential danger of the life insurance loan tax bomb is that it doesn’t matter how the loan accrued in the first place.
For instance, in the earlier scenario, it may be that Sheila actually borrowed out $100,000 from her policy, triggering its imminent collapse. The fact that Sheila only “used” $50,000 of the loan proceeds directly doesn’t change the outcome.
In some cases, a life insurance policy tax bomb is simply triggered by the fact that the policyowner stopped paying premiums at all. This is especially common in the case of whole life insurance policies, where technically it is a requirement to pay the premium every year (unless the policy was truly a limited-pay policy that is fully paid up), and if the policyowner stops paying premiums the policy will remain in force, but only because the insurance company by default takes out a loan on behalf of the policyowner to pay the premium (which goes right back into the policy, but now the loan begins to accrue loan interest). In turn, years of unpaid premiums leads to years of additional loans, plus accruing loan interest, can cause the policy to lapse. The end result: the policyowner never actually uses the life insurance loan directly, and finishes with a life insurance policy with a net cash surrender value of $0, and still gets a Form 1099-R for the underlying gain in the policy. Because the fact that premiums were paid via loans, for years, still doesn’t change the fact that it was a life insurance policy with a gain, even if all the underlying cash value was used to repay a personal loan (that, ironically, was used to pay the premiums on the policy itself!).
Or it’s possible that Sheila only borrowed $50,000 long ago, and years of unpaid (and compounding) loan interest accrued the balance up to $100,000, to the point that the policy would no longer sustain
Another scenario that can trigger a ‘surprise’ life insurance loan tax bomb is where the policy is using to as a “retirement income” vehicle, either through a version of the “Bank On Yourself” strategy, or simply by taking ongoing loans against the policy to supplement retirement cash flows, and the payday loan centers in Millington loans grow too quickly and cause the policy to lapse. Once again, even if the life insurance policy’s cash value is depleted to zero by ongoing policy loans, the lapse of the policy and the lack of any remaining cash value at the end doesn’t change the tax consequences of surrendering a life insurance policy with a gain (since in essence the gains were simply ‘borrowed out’ earlier and still come due!).