Can You Take Out Life Insurance Money?
Understand the different methods for accessing money from a life insurance policy, both for policyholders and beneficiaries.
Understand the different methods for accessing money from a life insurance policy, both for policyholders and beneficiaries.
Life insurance is a financial tool providing a safety net for loved ones following an insured’s passing. Beyond its primary purpose of offering a death benefit, many individuals wonder if they can access funds from their life insurance policy while living. This question arises from various financial needs, from unexpected expenses to retirement planning. Understanding how to utilize a life insurance policy during one’s lifetime, and the process for beneficiaries after the insured’s death, is important for maximizing the policy’s value. This article explores the various avenues through which life insurance money can be accessed, detailing the mechanisms and implications.
Life insurance policies generally fall into two main categories: term life insurance and permanent life insurance. Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years, and typically does not accumulate cash value. If the insured passes away within the specified term, a death benefit is paid to beneficiaries, but no funds are accessible during the insured’s lifetime from this type of policy.
Conversely, permanent life insurance policies, such as whole life and universal life, are designed to provide coverage for the insured’s entire lifetime and often include a cash value component. This cash value is a savings element that grows over time within the policy. A portion of each premium payment contributes to this cash value, which can also grow through investment returns or guaranteed rates, depending on the policy type.
The cash value accrues on a tax-deferred basis, meaning that any growth is not taxed until it is withdrawn or the policy is surrendered. This accumulated cash value is distinct from the death benefit, which is the amount paid to beneficiaries upon the insured’s death. The cash value is an asset that the policyholder may access while alive. It serves as the primary source of funds accessible during the insured’s lifetime for most permanent life insurance policies.
Policyholders of permanent life insurance can access the accumulated cash value through several methods, each with distinct mechanics and implications. These options allow for financial flexibility by leveraging the policy’s growing savings component. Understanding the differences between these methods is crucial for making informed decisions about accessing funds.
One common method is taking a policy loan, where the policyholder borrows money from the insurer using the policy’s cash value as collateral. These loans are not considered taxable income, as they are loans against the policy’s value, not withdrawals of earnings. Policy loans typically accrue interest, and if the loan and any accrued interest are not repaid, the outstanding amount will be deducted from the death benefit paid to beneficiaries when the insured passes away. The cash value continues to grow even when a loan is outstanding, as underlying investments remain intact, but the death benefit will be reduced if the loan is not repaid.
Another way to access funds is through cash withdrawals from the policy’s cash value. Unlike loans, withdrawals directly and permanently reduce both the policy’s cash value and the death benefit. Withdrawals are generally tax-free up to the amount of premiums paid into the policy, which is considered the policy’s cost basis. However, if the withdrawal amount exceeds the total premiums paid, the portion exceeding the cost basis may be subject to income tax. Withdrawn funds cannot typically be repaid to restore the death benefit or cash value.
Finally, a policyholder can surrender the policy, terminating the life insurance coverage entirely. When a policy is surrendered, the policyholder receives the cash surrender value, which is the accumulated cash value minus any surrender charges and outstanding loans. Surrender charges are fees imposed by the insurer, especially in the early years, to recover initial costs. The amount received upon surrender may be subject to income tax if it exceeds the total premiums paid into the policy. Surrendering a policy means losing death benefit coverage, so this option is generally considered a last resort for accessing funds.
Beyond directly accessing a policy’s cash value, alternative methods exist for policyholders to obtain funds from their life insurance during their lifetime, particularly under specific circumstances. These options typically involve accessing a portion of the death benefit before it would normally be paid out.
One such method involves accelerated death benefits, also known as living benefits, typically available through riders added to a life insurance policy. These riders allow the policyholder to receive a portion of their death benefit in advance if they meet certain criteria, such as being diagnosed with a terminal illness, chronic illness, or critical illness. For example, a terminal illness rider might allow access to funds if the insured has a life expectancy of 12 to 24 months. While these funds can help cover medical expenses or other needs, the amount received reduces the final death benefit paid to beneficiaries.
Another option, generally considered for those with a limited life expectancy, is a viatical settlement. In a viatical settlement, a policyholder sells their life insurance policy to a third-party company for a lump sum cash payment that is less than the full death benefit but more than the policy’s cash surrender value. This option is typically available to individuals who are terminally or chronically ill with a life expectancy of two years or less. The third party then takes over premium payments and receives the full death benefit upon the insured’s passing. The proceeds from a viatical settlement may be tax-exempt under certain conditions, particularly if the insured is terminally ill.
When the insured person passes away, beneficiaries named on the life insurance policy must initiate a claim to receive the death benefit. This process begins with notifying the insurance company of the insured’s death. Beneficiaries typically need to provide a certified copy of the death certificate and complete the insurer’s claim forms.
Once the claim is filed and approved, beneficiaries have several options for receiving the death benefit. The most common payout method is a lump sum, where the entire death benefit is paid in a single payment. Other options may include installment payments over a fixed period or for the beneficiary’s lifetime, or leaving funds with the insurer to earn interest, with the principal paid out at a later date. The choice of payout option can significantly impact how the funds are managed and distributed.
A significant advantage of life insurance death benefits is their general tax treatment for beneficiaries. In most cases, death benefit proceeds paid to beneficiaries are not subject to federal income tax. This tax-free status applies regardless of the payout option chosen, whether lump sum or installments. However, any interest earned on funds held by the insurance company, such as in an interest accumulation option, may be subject to income tax. While the death benefit itself is typically income tax-free, it is important to consider how funds are invested or managed after receipt, as subsequent earnings may be taxable.