When Borrowing Against Insurance, Beware of Taxes.

MARY Howard, 61, a reader on the Atlantic Coast, tells me she couldn't believe her eyes. She was staring at a tax notice. She owed income taxes on $47,300 in mysterious gains, from a life-insurance policy she had allowed to lapse.

It lapsed because she had borrowed too much against the policy's cash value. She never imagined that taxes might be due.

You might be traveling the same road, if you borrow against your insurance and don't repay.

Some 87 million cash-value policies are in force today. One of the selling points is that you can tap them for an easy loan, including a loan to pay the policy's premiums.

People typically don't repay their insurance loans. You think, "I owe that money to myself, so what's the big deal?" You might even be planning on taking policy loans in the future, to supplement your retirement income.

Howard had borrowed, off and on, for many years. The $200,000 Nationwide Life policy was on her husband's (now ex-husband's) life. She'd owned it since 1972.

But there's a limit to how much money you can take. If your loans grow to equal the policy' s cash value, the policy will collapse. The insurer will terminate the coverage.

Howard knew that her loans were building and that the policy could lapse. When that happened, however, she thought she'd be able to shrug her shoulders and walk away.

Alas, no such luck. When a cash-value policy collapses, income taxes are usually due. But Howard's agent never told her, and she got no tax alerts from Nationwide, as the loans built up.

"In this era of full disclosure and strict regulations to protect the public, I was never given any indication from any source that there were possible tax repercussions," Howard says.

Thousands of other people are on the same dangerous path, says Peter Katt, a fee-only life-insurance adviser in Kalamazoo, Mich. It's all too common for people to spend all their policy's cash values, without a clue as to what the consequences are.

Nationwide says that its agents aren't tax advisers, and in fact are instructed not to provide tax advice. Spokesman Bryan Haviland calls the Howard case "a rarity."

But it's not "tax advice" to tell people the consequences of ignoring policy loans. From time to time, Nationwide sent Howard a notice, suggesting that she repay. But the notice never mentioned the tax risk if the policy collapsed.

I agree with Howard, that we have a serious issue of nondisclosure here -- not just with Nationwide, but with virtually every insurer. Haviland says the company is "reviewing our correspondence policy."

Here's the general tax rule when a cash-value policy is canceled:

The insurer will compare your net investment in the policy (the premiums you've paid minus dividends received) with the policy's cash surrender value. If the cash value exceeds the net amount you've paid, you've got a taxable gain.

Normally, you receive the surrender value in cash and use the money to pay the tax. But first, the insurer subtracts any unpaid loans. If your loan is as large as the surrender value, you'll get zero cash. You'll have to find some other source of money to pay the tax.

That's the bind Howard is in today. Her terminated policy was worth $105,500 in cash (I'm rounding numbers here). Her net investment (premiums minus dividends) came to $58,200. That gave her a taxable gain of $47,300.

But she also had about $105,500 in loans. After subtracting her loans from the cash value, the insurer didn't owe her a dime. She had spent all the cash in advance. She has no idea how she's going to pay the IRS.

I asked Peter Katt to discuss this case with Nationwide. In theory, Howard could defer the tax by paying just enough loan interest to keep the policy on life support. If her ex-husband died, she'd get the net insurance amount, tax-free.

But the interest cost is high (and her ex is in good health). If she found that she couldn't continue the payments in the future, she'd owe the government even more in tax.

Howard says that she wouldn't have borrowed if she'd known about the tax. Or she might have surrendered the policy while it still had a comfortable net cash value.

Borrowing against life insurance looks so easy. But not many policyholders know what they're doing, Katt says. This debt takes careful management to keep you out of tax trouble.