Avoiding Common Pitfalls: Policy Loans, Surrenders, and Their Impact on Estate Taxes

High-net-worth (HNW) families in New York, California, Texas, and across the United States frequently use life insurance as a wealth-transfer and estate-liquidity tool. But policy loans, partial surrenders, and outright surrenders can create unintended income-tax and estate-tax consequences that erode the value of insurance in an estate plan. This guide explains the key mechanics, quantifies the tax stakes, and provides practical strategies to avoid costly mistakes.

Why this matters for HNW estates in the U.S.

• Federal estate tax: the 2024 federal estate and gift tax exemption is $13,610,000 per individual; amounts above that are taxed at a top federal rate of 40%. (Source: IRS)
• Many states (notably New York and California) have estate or inheritance taxes or quirks that further complicate planning; state thresholds are often far lower than federal exemptions, increasing exposure for wealthy residents of New York City, Los Angeles, and other high-net-worth hubs.
• Life insurance proceeds are income-tax-free to beneficiaries but may be included in the decedent's gross estate if the insured retained incidents of ownership (including policy ownership) or if certain incidents were present within three years of death.

Sources:

• IRS — Estate and Gift Taxes: https://www.irs.gov/businesses/small-businesses-self-employed/estate-and-gift-taxes
• New York State — Estate Tax (for state-specific planning): https://www.tax.ny.gov/pit/estate/estate_tax.htm

The core mechanics: loans, surrenders, and estate inclusion

Policy Loans

• When a permanent policy (whole life, universal life) accumulates cash value, the owner may borrow against the cash value. Loans typically:
  • Are not treated as taxable income while the policy remains in force and is not a Modified Endowment Contract (MEC).
  • Reduce the death benefit by the outstanding loan plus accrued interest if not repaid.
  • Accrue interest at carrier-determined rates (commonly 3%–8%, depending on carrier, product, and whether the loan rate is fixed or adjustable).
• Estate impact:
  • If the insured owned the policy or retained incidents of ownership at death, the gross death proceeds (including cash value) may be included in the gross estate; outstanding loans reduce the cash payable but the gross estate still reflects ownership interests and incidents of ownership.

Partial Surrenders / Withdrawals

• Some universal-life and variable universal-life policies permit withdrawals up to basis (cost) income-tax-free; gains above basis are taxable as ordinary income.
• Partial surrenders reduce cash value and potentially change the policy’s corridor; repeated withdrawals can unintentionally cause a policy to become a MEC (accelerating income-tax consequences).

Full Surrenders (Lapses)

• Fully surrendering a policy usually triggers income tax on the gain (cash surrender value minus basis). If the policy is a MEC, loans and withdrawals are taxed under a last-in/first-out rule and may trigger penalties if the insured is under age 59½.
• From an estate perspective, a surrendered policy removes death benefit protection and removes the asset from the estate, but may create liquid funds that become part of the taxable estate if held at death.

Quick comparative view: policy loan vs surrender

Real-world numeric illustration (New York resident, illustrative)

Assume a married couple in Manhattan with a combined gross estate of $25,000,000 including a $5,000,000 whole-life policy owned by the decedent. Using the 2024 federal exemption ($13,610,000):

• Taxable estate = 25,000,000 − 13,610,000 = 11,390,000
• Federal estate tax (40%) ≈ $4,556,000

If the $5,000,000 life policy is included in the decedent's estate (policy owner or incidents of ownership), it contributes directly to the gross estate. A well-structured irrevocable life insurance trust (ILIT) could remove the policy from the estate and reduce the taxable estate — potentially saving millions in federal (and state) estate tax.

Common pitfalls that cost HNW families

• Owning the policy personally instead of through an ILIT or properly funded trust — this automatically pulls the proceeds into the gross estate.
• Taking repeated loans or withdrawals that cause a policy to become a MEC, creating taxable distributions and penalties.
• Failing to monitor loan interest growth: loans can compound and outgrow cash value, causing unintended lapses and taxable events.
• Relying on surrender-generated cash to fund estate tax bills without considering income tax on gain and the loss of tax-free death benefit liquidity.

Practical solutions and best practices

• Use an ILIT (Irrevocable Life Insurance Trust) to own the policy and avoid estate inclusion, subject to gift tax/Crummey rules and three-year transfer rule if applicable.
• Avoid retaining any incidents of ownership (ability to change beneficiary, surrender, or borrow) if the goal is to exclude proceeds from the estate.
• If liquidity is the objective, consider standby lines of credit (bank or life-insurance-collateralized lines) rather than borrowing within the policy when possible; policy loans can be attractive short-term but can erode death benefit over time.
• Monitor policy loan balances and interest rates (loans commonly range from ~3%–8%) and run annual illustrations to avoid MEC triggers and lapses.
• Coordinate life insurance ownership with retirement distributions and gifting strategies to manage both gift/estate exposure and income-tax optimization.

Carrier considerations and pricing realities

Select carriers popular with HNW clients include Northwestern Mutual, MassMutual, Prudential, Lincoln Financial, and State Farm. Their approaches differ:

• Participating whole life carriers (Northwestern Mutual, MassMutual) offer dividend-paying policies with conservative illustrated returns but often require significant premium funding for larger face amounts.
• Universal life (indexed or variable) carriers (Prudential, Lincoln Financial) can provide flexible premium funding and attractive illustrated cash-value growth assumptions but require stricter oversight to avoid underfunding and lapses.

Pricing example (market illustration; actual quotes vary by age/health/state):

• A healthy 50-year-old client seeking $5,000,000 death benefit via a second-to-die survivorship policy may see upfront target funding in the hundreds of thousands to low millions depending on desired guaranteed vs illustrated funding levels with carriers like Lincoln Financial or Prudential.
• For term life comparators, on-line data aggregators (e.g., Policygenius) show term rates materially lower than permanent coverage; however, term cannot provide the long-term estate-liquidity certainty of properly owned permanent insurance.

For live quotes, consult carriers or brokers — sample rate research and market averages can be found on Policygenius: https://www.policygenius.com/life-insurance/term-life-insurance-rates/

Action checklist for advisors and HNW families (New York / California / Texas focus)

• Confirm ownership and beneficiary designations; remove incidents of ownership if the goal is estate exclusion.
• If an ILIT is used, ensure proper Crummey notices and trustee procedures are followed.
• Run funded/unfunded illustrations annually; stress-test for loan interest increases and market underperformance (for index or variable UL products).
• Evaluate state estate tax exposure (e.g., New York state rules) alongside federal exposure — many residents of NYC and LA face dual risks.
• Engage life-insurance carriers and financial institutions to shop pricing and guaranteed-funded options (Northwestern Mutual, MassMutual, Prudential, Lincoln Financial) and compare illustrations.

Related deep-dive resources:

• Why Life Insurance Is the Premier Wealth-Transfer Tool for High Net Worth Families
• Structuring Life Policies to Minimize Estate Inclusion and Preserve Family Wealth
• Policy Ownership Strategies: How Entity Relationships Affect Wealth Transfer and Taxes

Avoiding the policy-loan and surrender pitfalls requires proactive ownership design, regular monitoring, and coordination with estate tax projections. For HNW clients in New York, California, Texas, and other high-exposure states, the difference between a properly structured life insurance plan and an ad hoc loan/surrender strategy can be tax savings in the hundreds of thousands to millions of dollars.