A gentleman has a $2,000,000 whole life policy with an $800,000 loan. He wasn’t even aware of the loan until recently because his agent wasn’t helping manage the policy and the trustee didn’t understand what was going on.
Since he didn’t realize there was a loan he wasn’t paying loan interest so it was accumulating. Additionally, his agent told him years ago he didn’t have to pay the premium out of pocket and that the policy values would pay it for him. This turned out not to be true and his policy was in danger of collapsing with over $900,000 of gain at ordinary income tax rates.
The policy premium of $25,000/yr was being added to the loan annually while $56,000 of dividends was buying additional insurance. This is ludicrous. We changed the dividend option to pay the premium so the loan wouldn’t keep growing. Since the loan had an interest rate of 8%, this left $64,000 of loan interest of which $31,000 could be paid by the remaining dividends. But who would knowingly accept an 8% loan?
We ended up refinancing the loan for 3.75% which saved him $34,000 in interest annually. This was enough to pay the interest on the new loan with a little bit left over to start paying down the loan. As the policy dividends grow they loan principal can be paid down more.
The policy is now performing better than it was, has a full $2,000,000 tax free death benefit, there is a much lower debt service and hundreds of thousands of taxes have been avoided. It almost seems to good to be true but it is because someone paid attention.
A policy owner was referred to me in a state of panic after she was informed her policy was almost completely loaned out and a very large check was due for premium and loan interest to keep the policy from lapsing with a large taxable gain on phantom income.
The policy owner had no understanding of this and was completely unaware the loan was growing like it was and would eventually collapse the policy.
Even if she could come up with the cash to pay the required premium and interest, it would be due year after year. We could made structural changes to the policy to keep it from getting worse as quickly as it has been but a solution was outside of her financial capacity and letting the policy lapse was out of the question as the tax consequence would nearly bankrupt her.
Ultimately, we surrendered some paid up additions to reduce the loan, changed the dividend option and refinanced the loan at half the interest rate allowed the policy to better self regulate and the huge interest savings could manage the debt service. While the policy can never be reconstructed to what she expected it to be, we could help salvage it and keep a few hundred thousand of taxable phantom gain at bay.