The owner of a Value-Added Whole Life insurance policy can borrow up to 75% of the cash value of the policy. Interest is charged at a variable rate of 1% over the current crediting rate. For 2010, the crediting rate is 7% and the loan interest rate is 8%. Interest is billed on the anniversary date of the loan. If unpaid, the interest is added to the outstanding amount. A difficulty arises when the interest is unpaid for a relatively long period of time. If the outstanding amount of the loan plus accrued interest becomes greater than the cash value, the policy will lapse because there is no cash value left to support the policy.
There are two parts to the cash value of a policy; premiums paid in and that part above the premiums paid in, or gain. A taxable event occurs when the policy lapses. The difference between the loan including accrued interest (which is greater than the cash value) and the premiums paid in is taxable as ordinary income. AAFMAA is required to issue a 1099-R to the owner of the policy with a copy to the IRS. The theory is that the owner of the policy had the use of the money, some in the form of the loan and some used to pay the interest. Taxes have not been paid on the growth. According to the IRS, this amount is taxable. If you are considering taking a loan against your policy, we strongly encourage you to pay at least the interest annually. This will help avoid a lapse situation and possible tax impact. Please consult a tax professional for more detailed information.