Can Life Insurance Be Used While Alive?

Life insurance policies primarily provide a financial safety net for beneficiaries after the policyholder’s passing. Beyond this traditional role, certain life insurance structures can offer financial liquidity and support to the policyholder while they are still alive, allowing access to policy value or benefits under specific conditions.

Accessing Policy Cash Value

Certain types of permanent life insurance, such as whole life and universal life policies, accumulate a cash value component over time. This cash value grows on a tax-deferred basis, distinct from the policy’s death benefit, and policyholders can access these accumulated funds during their lifetime for various financial needs.

One common method for accessing cash value is through a policy loan. Policyholders can borrow against their accumulated cash value, and the policy itself serves as collateral for the loan. The policy generally remains in force while the loan is outstanding, and the insurer charges interest on the borrowed amount, typically at a variable or fixed rate. Repayment of the loan is often flexible, with no strict repayment schedule, although any outstanding loan balance will reduce the death benefit paid to beneficiaries.

Alternatively, policyholders can make a direct cash withdrawal from the policy’s cash value. Unlike a loan, a withdrawal permanently reduces the policy’s cash value and, consequently, the death benefit. Withdrawals are generally treated as a return of premium up to the amount of premiums paid into the policy, and these amounts are typically not taxable. However, if the withdrawal amount exceeds the total premiums paid, the excess portion may be subject to income tax. Unlike withdrawals, loans do not typically trigger a taxable event unless the policy lapses with an outstanding loan.

Utilizing Living Benefits Riders

Living benefits, also known as accelerated death benefits, are riders that can be added to a life insurance policy, allowing the policyholder to access a portion of their death benefit while still alive. These benefits provide financial relief during challenging life circumstances, helping cover medical expenses, long-term care costs, or other financial burdens that arise from qualifying conditions.

Common qualifying conditions for activating living benefits include terminal illness, where a physician certifies a life expectancy of 12 to 24 months, depending on the policy and state regulations. Another condition is chronic illness, typically defined as the inability to perform at least two out of six activities of daily living (ADLs) such as bathing, dressing, eating, toileting, transferring, or continence, or requiring substantial supervision due to severe cognitive impairment. Critical illness, such as a heart attack, stroke, or cancer diagnosis, can also trigger these benefits on some policies.

Upon approval, the policyholder receives a lump sum payment or periodic payments, which is a portion of the policy’s death benefit. The amount received reduces the death benefit that would otherwise be paid to beneficiaries upon the policyholder’s death. For instance, if a policy has a $500,000 death benefit and a $100,000 living benefit is exercised, the remaining death benefit for beneficiaries would be $400,000. Additionally, accessing these benefits may reduce the policy’s cash value. Under the Health Insurance Portability and Accountability Act of 1996 (HIPAA), payments received from an accelerated death benefit for a terminally or chronically ill individual are generally excluded from gross income for federal tax purposes, provided certain requirements are met.

Selling Your Life Insurance Policy

Policyholders can also access value from their life insurance policy by selling it to a third party through a process known as a life settlement. This option allows individuals to receive a lump sum of cash for a policy they no longer want or can afford. This is an external transaction where the policy’s ownership is transferred to an investor, unlike accessing cash value or living benefits, which are internal policy features.

There are two primary types of settlements: viatical settlements and life settlements. A viatical settlement specifically applies to policyholders who are terminally ill, typically with a life expectancy of two years or less. A life settlement generally applies to policyholders who are typically healthy seniors, often aged 65 or older, with a life expectancy of 15 years or less. In both cases, the policyholder sells their policy for an amount greater than its cash surrender value but less than the full death benefit.

The general process involves the policyholder selling their policy to a life settlement provider or investor. The new owner then becomes responsible for paying all future premiums and receives the full death benefit when the original policyholder passes away. The lump sum received by the policyholder can be used for any purpose, such as covering medical expenses, long-term care, or supplementing retirement income. The proceeds from a life settlement may be subject to federal income tax, depending on the policy’s cost basis and the amount received. Generally, the portion representing premiums paid is tax-free, while amounts exceeding that basis may be taxed as ordinary income or capital gains.