Can You Pull From Life Insurance While Alive?

Understanding Cash Value Policies

Life insurance policies primarily provide financial protection to beneficiaries after the policyholder’s death. However, certain types of life insurance offer a “cash value” component, which can be accessed during the policyholder’s lifetime. This feature distinguishes these policies from term life insurance, which provides coverage for a specific period and does not accumulate cash value.

Cash value represents a portion of the premiums paid that accumulates on a tax-deferred basis over the policy’s life. This accumulated value grows through guaranteed interest rates, investment returns, or a combination of both, depending on the policy type. This accumulated value can serve as a living benefit, offering a source of funds.

Whole life insurance is a permanent policy that builds cash value at a guaranteed rate, providing predictable growth. Universal life insurance policies offer more flexibility in premium payments and death benefits, with cash value growth often tied to current interest rates. Variable universal life insurance allows policyholders to invest the cash value in sub-accounts, offering potential for higher returns but also carrying investment risk.

Accessing Your Policy’s Cash Value

Policyholders can access the cash value accumulated within their permanent life insurance policies through several methods. Each method has specific mechanics and consequences that can impact the policy’s future benefits.

Policy Loan

One common way to access cash value is through a policy loan. Policyholders can borrow money directly from their policy, using the accumulated cash value as collateral. The loan amount reduces the available cash value and accrues interest, similar to a traditional loan, often at a rate between 5% and 8% annually.

If the loan is not repaid, the outstanding balance, including accrued interest, will be deducted from the death benefit paid to beneficiaries upon the insured’s death. Unpaid policy loans can also lead to the policy lapsing if the outstanding loan plus interest exceeds the policy’s cash value, potentially resulting in taxable income for the policyholder. Unlike traditional loans, there is no set repayment schedule. The policy remains in force as long as the cash value, less the loan amount, can cover ongoing policy charges.

Cash Withdrawal

Another method is to make a cash withdrawal directly from the policy’s cash value. Unlike a loan, a withdrawal permanently reduces the policy’s cash value and, consequently, the death benefit amount. Withdrawals are generally considered tax-free up to the amount of premiums paid into the policy, which is referred to as the “cost basis.” Any amount withdrawn that exceeds the cost basis may be subject to ordinary income tax.

For policies classified as Modified Endowment Contracts (MECs), withdrawals are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are considered to be withdrawn first and are subject to ordinary income tax. Additionally, withdrawals from MECs made before age 59½ may incur a 10% federal income tax penalty.

Surrender Policy

A policyholder can choose to surrender the life insurance policy. Surrendering a policy means terminating the coverage entirely in exchange for the policy’s cash surrender value. The cash surrender value is the accumulated cash value minus any outstanding loans, unpaid premiums, and surrender charges, which are fees applied by the insurer, especially in the early years of the policy.

Surrendering a policy ends all life insurance coverage, meaning no death benefit will be paid to beneficiaries. Any amount received that exceeds the total premiums paid into the policy may be considered taxable income. This option removes the financial protection the policy was designed to offer.

Using Accelerated Death Benefits

Beyond accessing cash value, certain life insurance policies offer accelerated death benefits, also known as living benefits or living benefit riders. These allow policyholders to receive a portion of their death benefit while still alive, triggered by specific qualifying life events. The availability of these riders varies by insurer and policy.

Terminal Illness

One common trigger for accelerated death benefits is a terminal illness, where the policyholder has a life expectancy of 12 to 24 months, as certified by a medical professional. This benefit allows policyholders to use a percentage of their death benefit to cover medical expenses, home care, or other needs. The amount received reduces the death benefit paid to beneficiaries.

Chronic Illness

Chronic illness is another qualifying condition, often defined as the inability to perform a certain number of Activities of Daily Living (ADLs), such as bathing, dressing, or eating, or requiring substantial supervision due to cognitive impairment. This benefit can help cover long-term care costs, allowing individuals to maintain their independence or receive necessary care at home or in a facility. The policyholder receives monthly payments up to a certain percentage of the death benefit.

Critical Illness

Critical illness riders provide a payout if the policyholder is diagnosed with a specific severe illness, such as a heart attack, stroke, life-threatening cancer, or kidney failure. The list of covered illnesses varies by policy, and a medical diagnosis is required to trigger the benefit. These funds can be used to cover medical treatments, lost income during recovery, or other financial burdens associated with the illness.

Claim Process

Claiming accelerated death benefits involves submitting a claim to the insurance company with medical documentation certifying the qualifying condition. The insurer reviews medical records to determine eligibility and the percentage of the death benefit that can be advanced. The remaining death benefit is paid to beneficiaries upon the policyholder’s death.

Tax Implications

Accelerated death benefits for qualified terminal or chronic illnesses are generally considered tax-free under federal law, provided they meet specific criteria. However, critical illness benefits may be taxable if the funds are not used for qualified long-term care expenses or medical costs. Receiving these benefits may also impact eligibility for certain government assistance programs, such as Medicaid, as the payout can be considered an asset.