Can You Take Money From Life Insurance?

Life insurance primarily provides a financial safety net for beneficiaries upon the insured’s passing. However, certain types of life insurance policies can also serve as a financial resource during the policyholder’s lifetime. Understanding the various ways to access money from these policies is important for individuals seeking to leverage their insurance for immediate financial needs.

Understanding Cash Value Life Insurance

Life insurance policies typically fall into two broad categories: term life and permanent life. Term life insurance provides coverage for a specific period and does not build cash value. Permanent life insurance, conversely, includes a savings component known as cash value, which accumulates over the policy’s lifetime. This cash value grows on a tax-deferred basis, meaning earnings are not taxed until they are withdrawn.

The accumulation of cash value occurs as a portion of each premium payment is allocated to this savings component, separate from the cost of insurance. This component can grow through guaranteed interest rates, flexible interest rates tied to market performance, or investment-linked returns, depending on the policy type.

Common types of permanent life insurance that build cash value include Whole Life, Universal Life, and Variable Universal Life. Whole Life policies offer guaranteed cash value growth at a fixed rate. Universal Life policies provide more flexibility in premiums and their cash value growth is often based on market interest rates with a guaranteed minimum. Variable Universal Life policies allow the policyholder to invest the cash value in various sub-accounts, offering potential for higher returns but also greater risk.

Direct Methods for Accessing Policy Funds

Policyholders can directly access the accumulated cash value within their permanent life insurance policies through several common methods. These options offer financial flexibility but also impact the policy’s future benefits.

Policy Loans

One common approach is taking a policy loan, where the policyholder borrows against the cash value as collateral. The loan is taken from the insurer and is generally not considered taxable income, provided the policy remains in force. Interest accrues on these loans. While repayment schedules are flexible, any unpaid loan balance, including interest, will reduce the death benefit paid to beneficiaries. If the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the premiums paid can become taxable.

Cash Withdrawals

Another method is to make a cash withdrawal from the policy’s cash value. Withdrawals directly reduce the cash value and, consequently, the death benefit. The amount withdrawn up to the total premiums paid into the policy (known as the cost basis) is generally tax-free. However, any amount withdrawn that represents a gain above the cost basis is typically taxable as ordinary income.

Policy Surrender

Policy surrender involves terminating the life insurance contract entirely to receive its cash surrender value. The cash surrender value is the accumulated cash value minus any surrender charges and outstanding loans. Surrender charges can be substantial, especially in the early years of a policy, often ranging from 10% to 35% of the cash value, and typically decrease over time. When a policy is surrendered, any amount received that exceeds the total premiums paid is generally taxed as ordinary income.

Specialized Access Options

Beyond direct access methods, specialized options exist for accessing life insurance funds, often under specific circumstances. These alternatives typically involve a reduction in the policy’s death benefit or a transfer of policy ownership.

Accelerated Death Benefits

Accelerated Death Benefits, also known as living benefits riders, allow policyholders to receive a portion of their death benefit while still living if they meet specific criteria. These benefits are typically available for individuals diagnosed with a terminal illness, often with a life expectancy of 24 months or less, or for chronic illnesses requiring long-term care. The funds received reduce the final death benefit paid to beneficiaries, and generally, these benefits are tax-exempt if certain conditions, such as medical certification of illness, are met.

Life Settlements and Viatical Settlements

Life settlements and viatical settlements involve selling a life insurance policy to a third-party investor. In a viatical settlement, the policyholder is typically terminally or chronically ill, and the proceeds are generally tax-free. The investor takes over premium payments and receives the death benefit when the insured dies. Viatical settlements often result in higher payouts, averaging 50-70% of the death benefit, compared to life settlements, because the buyer anticipates fewer premium payments.

A life settlement is similar but typically involves a policyholder who is not terminally ill, though they may be elderly or have certain health conditions. The policyholder receives a lump sum, which is generally more than the cash surrender value but less than the full death benefit. The investor then assumes premium payments and becomes the beneficiary.

Financial Implications of Accessing Funds

Accessing funds from a life insurance policy carries various financial implications, particularly concerning taxation and the policy’s long-term viability. Understanding these consequences is vital for informed decision-making.

Tax Considerations

The tax treatment of accessed funds varies significantly by method and policy type. Policy loans are not taxed unless the policy becomes a Modified Endowment Contract (MEC) or lapses with an outstanding loan. If a policy is classified as an MEC due to overfunding beyond IRS limits, loans and withdrawals are taxed differently; earnings are taxed first (LIFO method), and a 10% penalty may apply if the policyholder is under age 59½.

If accelerated death benefits exceed IRS limits for chronic illness and are not used for qualified long-term care expenses, a portion could become taxable. Life settlements are subject to a tiered tax structure: proceeds up to the cost basis are tax-free, amounts exceeding the basis but below the cash surrender value are taxed as ordinary income, and any amount above the cash surrender value is taxed as capital gains.

Impact on Death Benefit and Policy Viability

Any method of accessing funds, whether through loans, withdrawals, or settlements, will reduce or eliminate the death benefit payable to beneficiaries. This can diminish the financial protection intended for loved ones. Furthermore, significant withdrawals or outstanding policy loans can deplete the cash value to a point where it can no longer cover policy charges, increasing the risk of policy lapse. A policy lapse with an outstanding loan can create an unexpected taxable event. If the policy is not surrendered, premium payments may still be required to maintain coverage, even after funds have been accessed.