Today’s topic will not affect very many people. Did I just encourage you to skip reading the article? Hopefully, you do not tune out because, for those today’s topic does affect, the information may prevent financial disaster.

Cash value life insurance, such as whole life and some universal and variable policies, permit cash value to build within the policy. During life, the policyholder may be tempted to borrow from the cash value. Cash value is also a countable resource for some public assistance, but that is not today’s topic.

Loans against cash value accrue interest like any other loan. Loans may arise either from borrowing money against the policy or using the cash value to pay premiums. If all goes well, the loan does not threaten policy continuation.

If, however, accrued interest and unpaid principal grow to equal the death benefit, the policy may automatically terminate. The life insurance company may then report the entire unpaid amount as income. The income is usually a shocking and unexpected amount which triggers high tax liabilities, not to mention the unexpected loss of the life insurance policy.

Variable, universal, and single-premium policies are most at risk. I worked on a case several years ago which resulted in an additional $50,000 of federal and state income taxes. The situation was easily preventable, had the policyholder understood what to do.

If you have a loan against life insurance cash value or know someone who does, here are a few tips to prevent disaster:

1. Pay accruing interest regularly. This prevents the loan balance from growing exponentially. Had my client paid less than $1,000 toward interest, the additional $50,000 tax would have been avoided.
2. Obtain an analysis of the policy from a competent advisor. Policy dividends may offset loan interest, and an analysis explains when the policy could implode.
3. Monitor investment returns in the policy. Universal policies are especially sensitive to poor market performance.
4. Monitor premium adjustments. Variable policies have adjustable premiums which may accelerate unintended cancellation of the policy.

Once the policy cancels, there is no going back. Action before policy cancellation is necessary to prevent financial disaster.