Universal life insurance can help you and your family long before you're dead. As you pay the premiums, your policy acquires a cash value. You can take out a loan against the accumulated cash value and you don't even have to pay it back -- the insurer can simply take the principal and interest out of your death benefit. Using your life insurance as a lender can have harmful tax consequences.
If you run into financial trouble when you're young, letting life insurance lapse might seem like an easy out. After all, it should be years before you need it. If you've already taken out a loan, that's a mistake: If you let the policy lapse with the loan still in force, the Internal Revenue Service treats the accumulated interest as taxable income. It's phantom income, of course -- you haven't received a penny of it -- but you still have to pay the taxman.
Another option if you discontinue your policy is to surrender it: Terminate the policy and collect whatever cash value it has. If the policy is worth more than your "basis" -- the amount you've spent on it over the years -- the IRS treats the excess as taxable income. Whatever you may have borrowed over the years counts, too. If your basis is $11,000, you owe $6,000 including interest and you receive a $12,000 payout, you have $7,000 in taxable income.
Because you don't have to make monthly payments on a life-insurance loan, it's easy to lose track of how much interest the original loan is accumulating. If you just shove mail from your insurance company into a drawer or a trash basket, stop. Check the letters and see if any of them update you on how much you owe. If you're not receiving updates, call your agent and ask for the information. You may be shocked at how much you're on the hook.
Taxes aren't the only thing to consider when taking out a life-insurance loan. If you're in your early 20s, for example, and you keep paying your premiums, the interest will keep growing for years. This is risky if you intend the life insurance to help your spouse or kids after you're gone. By the time you die, the original loan plus interest may take a substantial bite out of your death benefit. Like any other loan, the sooner you pay it off, the less interest you'll have to pay.