Are You Supposed to Use Life Insurance While Alive?
Explore the unexpected ways life insurance can provide financial flexibility and support for you during your lifetime.
Explore the unexpected ways life insurance can provide financial flexibility and support for you during your lifetime.
While life insurance is traditionally seen as a financial tool for beneficiaries after a policyholder’s death, many modern policies offer features that allow individuals to access benefits and value during their lifetime. These living benefits provide financial flexibility and support, extending the utility of life insurance beyond its death benefit.
Permanent life insurance policies, such as whole life and universal life, accumulate cash value over time, unlike term life insurance. This cash value grows tax-deferred and can serve as a financial resource during the policyholder’s lifetime. There are several mechanisms to access this value.
One common method for accessing cash value is through a policy loan. Policyholders can borrow against the cash value, with the policy serving as collateral. These loans typically do not require a credit check and often have competitive interest rates. While repayment is flexible, any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries.
Another option is a cash withdrawal from the policy’s accumulated value. Withdrawals directly reduce the cash value and can also decrease the death benefit. Funds withdrawn up to the amount of premiums paid into the policy (cost basis) are generally tax-free. However, any amount exceeding this cost basis is typically taxable income.
A third method is policy surrender, involving the complete cancellation of the policy in exchange for its surrender value. This value is the cash value minus any applicable charges. While surrendering provides access to a potentially larger sum, it terminates all life insurance coverage. Any gain received upon surrender, defined as the surrender value exceeding total premiums paid, is subject to ordinary income tax.
Beyond accessing cash value, certain policy features, often riders, allow policyholders to receive a portion of their death benefit while living, typically under specific health-related circumstances. Known as accelerated death benefits or living benefits, they provide financial relief during challenging times.
A terminal illness rider allows access to a portion of the death benefit if the policyholder is diagnosed with a terminal illness and has a limited life expectancy, often 12 to 24 months or less. The funds can be used for medical expenses, hospice care, or other needs. This early payout reduces the amount beneficiaries will receive.
Chronic illness riders provide access to funds if the policyholder becomes chronically ill, meaning they are unable to perform a certain number of Activities of Daily Living (ADLs), typically two out of six, or suffer from severe cognitive impairment. These benefits often help cover long-term care expenses, whether for in-home care or a facility.
Critical illness riders offer a lump-sum payment upon diagnosis of a specified critical illness, such as a heart attack, stroke, or certain cancers. Qualifying conditions are defined within the rider and vary by insurer. This lump sum can be used for various expenses, including medical treatments or household bills during recovery.
Long-term care riders, sometimes integrated with chronic illness benefits, allow policyholders to use their death benefit to cover long-term care costs. These riders typically have specific triggers, such as the inability to perform ADLs, and may offer benefits as a percentage of the death benefit monthly, often 1% to 4%. These hybrid policies combine life insurance with long-term care coverage.
Accessing policy cash value or utilizing accelerated death benefits carries significant financial implications. These actions directly affect the future value of the policy and its benefits. The primary consequence is a reduction in the death benefit paid to beneficiaries. Any amount borrowed, withdrawn, or advanced through a rider will decrease the final payout, potentially leaving beneficiaries with less financial support.
Tax implications are a key consideration when accessing life insurance funds. Cash value withdrawals are generally tax-free up to the policyholder’s cost basis (total premiums paid). Any portion exceeding this cost basis is taxable as ordinary income. Policy loans are generally not taxable income as long as the policy remains in force. If a policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the cost basis can become a taxable distribution.
Accelerated death benefits paid to terminally or chronically ill individuals are generally excluded from federal income tax under IRS guidelines. For terminal illness, this exclusion typically applies if a physician certifies an expectation of death within 24 months. For chronic illness, benefits must be used for qualified long-term care expenses, and there may be daily or periodic limits on the tax-free amount, with any excess potentially taxable. Critical illness riders may have different tax treatment depending on whether they qualify under terminal or chronic illness provisions.
Policy lapse risk is another financial consideration, particularly for policies where loans or withdrawals significantly deplete the cash value. If cash value falls below a certain threshold, the policy may lapse if premiums are insufficient to maintain coverage. This can occur if loans are not repaid and accumulating loan interest erodes the cash value. Policyholders must continue premium payments or ensure sufficient cash value remains to prevent unintended termination. Any use of policy features while alive should be carefully evaluated against the policy’s long-term goals.