Borrowing from whole life policy and taxes 1099-R

sydneysteve

New member
I have a tax-related question that centers around a $50,000 loan my wife and I took out in 2023 from her whole life insurance policy, which originally involved a one-time premium payment of $50,000 in 2016. The base cash value at the time of borrowing stood at $59,500, plus $2,200 in paid-up additions, totaling $61,700.

And now we received a 1099-R, with a listed taxable amount of $11,700 in box 2a, with distribution code 1D in box 7. As far as I understand, this $11,700 represents the difference between the accumulated cash value and the $50,000 we borrowed. My initial assumption was that borrowing from a whole life policy would not incur tax implications, especially since the borrowed sum did not exceed the original upfront premium paid in 2016.

However we did opt to have dividends earned applied to the loan on the policy's annual birth date. Despite this, the dividends earned were significantly less than the $11,000 stated on the 1099-R. Could this election be the trigger for the taxable event? My attempts to seek clarity from the policy service department have been unsuccessful, leaving me without a definitive understanding of why there's a taxable amount of $11,000.

They provided me with this explanation for the taxable gain, calculation reads as follows:

"The taxable gain is calculated as:

Base Cash Value: $59,000

Plus (+) paid-up additions: $2,200

Subtract (-) adjusted cost basis: $50,000

Equals: Tax Gain Amount: $11,700"

My main thing is we borrowed $50,000 and did not withdraw it, why is there a taxable amount? and I've been making monthly payments on the loan, inclusive of the 8% interest it accrues.

I'm just really confused and am seeking clarity from all of this, any insights?
 
@sydneysteve If the policy is still in force and has not lapsed your loan should not be a taxable event unless the $50k initial premium made the policy a MEC. If that is the case than you destroyed the tax advantages of life insurance from the get go.
 
@dinkold Single premiums are almost always a MEC.

There can be good MECs too...

Hybrid LTC, Single pay whole life/iul strictly for death benefit and safety, alternative to an annuity, etc.

But I agree with you. If this was OP's intention (taking a loan), then this design won't work.
 
@dinkold You can't solve for min non mec DB on a single pay. They're considered a MEC by default.

There would have to be a 1035 or something else involved.
 
@dinkold
Now it may end up taking more than one premium

That's not a single pay. You can have a large up front payment and then pay annually to pass testing but a single pay, non 1035, will always be a MEC.

The IRS literally specifies that.
 
@qity Let me give you a scenario when you would solve for the DB that would make a large initial premium not create a MEC. Say you have a wealthy family as clients. Their No 1 son completes medical school and surgical residency but decides to spend some years working for Doctor's W/O Borders and then come back to practice in his lucrative profession. Either he or his parents want to get him some LI but don't want him to have to pay premiums so they want you to design a life policy that would take an initial premium of $50,000 and run for the years he is in Africa without further premiums but would be available for him to restart premiums when he returns to the States. You would calculate the minimum DB that would not cause the initial premium to become a MEC because you don't want to make the policy worthless to him as a wealthy surgeon in the future.
 
@dinkold I agree with that but that is not a single premium.

You can pass testing at any point and have it not be a MEC. You can't pass testing without additional premiums.

I think I'm just being picky on the "one premium" thing here. They made one payment in 2016 so they would be unable to "fix" this policy like you described.

That's all I'm saying. Not trying to be pedantic.
 
@jeshurun1111 Since Aug of 88 any true single premium product is a MEC. But OP simply said one time premium, leaving open whether or not future premiums were possible or planned. It is some of the commentors that jumped to that conclusion.

But a Q. Do you know who the most successful and prolific sales person on SPWL was in the pre MEC days (86-88)? The days of 9% taxable CD rates but 8% tax free SPWL rates? The days of a variable SPWL with an 0.6% life insurance cost and whatever else was earned a tax free earning?
 
@sydneysteve Your policy is a MEC (modified endowment contract). It doesn't have the same tax advantages as a traditional cash value life policy would.

It's going to be taxed like a NQ annuity.

Hopefully, I'm wrong. Because if I'm not when you file your taxes, you're going to have a 10% IRS penalty on those gains as well (assuming you're under age 59.5).

EDIT: You're also being taxed on the gain because like non-qual annuities, MECs are LIFO tax treatment (last in, meaning interest, first out, meaning that money comes out first and is taxable). This applies to loans from a MEC as well.

A non-mec life policy has FIFO (first in, first out) treatment meaning you can withdraw to basis without tax implications. It also allows for loans without taxation (assuming that the policy stays in force).
 
@qity Thank you for your reply. The name of the policy is "Single Premium Whole Life".

Forgive me but I am naive on this topic. How would I find out If the policy is an MEC exactly?
 
@sydneysteve Single pay WL is almost always a MEC. You can call the carrier and ask them but it likely is on the original illustration that you signed when you applied for the policy as well.
 
@kimhealth Don't overfund it. The company can tell you what the annual limits are.

And keep your address current. If you do remit too much and it becomes a MEC, they will notify you. You do have a short time frame to reverse the overpayment and the MEC status.
 

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