Can I Use My Life Insurance Before I Die?

Life insurance primarily provides a death benefit to beneficiaries upon the policyholder’s passing. However, certain policies also offer accessible funds or benefits during the policyholder’s lifetime, addressing immediate financial needs or long-term care requirements.

Accessing Policy Cash Value

Permanent life insurance policies, such as whole life, universal life, and variable universal life, accumulate a cash value component over time, unlike term life. This cash value grows on a tax-deferred basis, offering a source of funds policyholders can access during their lifetime.

Policyholders can borrow against their cash value through a policy loan, with the policy serving as collateral. These loans are generally not considered taxable income as long as the policy remains in force, as they are viewed as a debt. Interest accrues on the loan, and any outstanding balance, including unpaid interest, will reduce the death benefit paid to beneficiaries. If the policy lapses or is surrendered with an unpaid loan, the outstanding loan amount exceeding the policy’s cost basis may become taxable income.

Policyholders can withdraw a portion of their cash value, which directly reduces the policy’s cash value and death benefit. Withdrawals are generally tax-free up to the amount of premiums paid into the policy, known as the “cost basis.” The cost basis represents the total premiums paid into the policy. Any amount withdrawn exceeding this cost basis may be subject to ordinary income tax. Certain permanent policies may not allow withdrawals or could trigger surrender charges.

Policy surrender involves terminating the life insurance policy completely in exchange for its cash surrender value. This ends all coverage and eliminates the death benefit. The cash surrender value is the accumulated cash value minus any applicable surrender charges and outstanding loans. If the cash surrender value received exceeds the policy’s cost basis, the excess amount is generally taxable as ordinary income. The insurance company may issue a Form 1099-R to report the taxable portion.

Utilizing Living Benefits

Life insurance policies can include specific riders, known as “living benefits” or “accelerated death benefits,” allowing policyholders to access a portion of their death benefit under certain health-related circumstances. These riders provide financial support for medical care or other needs. They are typically optional additions, though some may be built-in.

Accelerated Death Benefits (ADB) allow policyholders diagnosed with a terminal illness to receive a portion of their death benefit. A terminal illness is typically defined as having a life expectancy of 24 months or less. These benefits are generally tax-free if the insured is certified by a physician as terminally ill and expected to die within 24 months.

Chronic Illness Riders provide funds if the policyholder is unable to perform a specified number of Activities of Daily Living (ADLs), typically two out of six, or requires substantial supervision due to severe cognitive impairment. These funds can cover long-term care expenses, such as home healthcare or assisted living. While generally tax-free if used for qualified long-term care expenses, amounts exceeding daily IRS limits may be taxable.

Critical Illness Riders offer a lump-sum payout upon the diagnosis of a specific critical illness, such as cancer, heart attack, stroke, or kidney failure. This payout can help cover medical expenses, lost income, or other associated costs. The tax treatment of critical illness benefits depends on whether the condition also qualifies as a terminal or chronic illness under IRS rules.

A policy that becomes a Modified Endowment Contract (MEC) due to overfunding can alter the tax treatment of withdrawals and loans. If a policy fails the “7-pay test,” meaning premiums paid exceed a certain limit within the first seven years, it is reclassified as a MEC. For MECs, withdrawals and loans are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are taxed first, and a 10% penalty may apply if the policyholder is under age 59½. The death benefit from a MEC generally remains tax-free for beneficiaries.

Transferring Policy Ownership

Beyond accessing cash value or utilizing living benefits, policyholders can transfer ownership of their life insurance policy to a third party. This involves selling the policy for a cash sum, providing an alternative to surrendering it. This option is relevant for individuals who no longer need or can afford their policy.

Viatical settlements are for policyholders who are terminally ill, often with a life expectancy of two years or less. The policyholder sells their life insurance policy to a third-party viatical settlement provider for a percentage of the death benefit. The provider becomes the new owner and beneficiary, assuming responsibility for future premiums. Proceeds from viatical settlements are generally not subject to federal income tax if the insured is certified as terminally ill with a life expectancy of 24 months or less, or if chronically ill and funds are used for qualified long-term care expenses.

Life settlements are similar but are typically for policyholders generally age 65 or older and not terminally ill, though they may have a reduced life expectancy. The policyholder sells their policy to a life settlement company for a sum greater than the policy’s cash surrender value but less than the full death benefit. The company takes over premium payments and receives the death benefit upon the insured’s passing.

Both viatical and life settlements offer a higher payout than simply surrendering the policy for its cash surrender value. The original policyholder gives up the death benefit, meaning beneficiaries will not receive any payout. Proceeds from a life settlement are typically taxable. Taxation follows a tiered structure: proceeds up to the policy’s cost basis are tax-free, amounts exceeding the cost basis up to the cash surrender value are taxed as ordinary income, and any remaining proceeds above the cash surrender value are taxed as capital gains. For example, if a policy sells for $110,000 with a $50,000 cost basis and $55,000 cash surrender value, the gain of $60,000 would be taxed as $5,000 ordinary income and $55,000 capital gains.