Can You Use Life Insurance While You’re Still Alive?

Life insurance primarily provides financial protection for beneficiaries after the insured’s passing. However, certain types of life insurance policies offer mechanisms allowing policyholders to access funds during their lifetime. These options can provide financial flexibility and support for various needs.

Understanding Policy Types

Life insurance policies are broadly categorized into two main types: term life and permanent life insurance. Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years. This type of policy does not accumulate cash value, meaning it does not offer a direct mechanism to access funds while the insured is alive.

Permanent life insurance policies, which include whole life, universal life, and variable universal life, are designed to remain in force for the insured’s entire life. These policies feature a cash value component that grows over time on a tax-deferred basis. This accumulated cash value is the fundamental element that enables policyholders to access funds during their lifetime.

Utilizing Cash Value

Permanent life insurance policies allow policyholders to access their accumulated cash value through two primary methods: policy loans and cash withdrawals or partial surrenders. These options provide liquidity, but they also carry specific financial and tax implications.

Policy loans enable the policyholder to borrow money directly from the insurer, using the policy’s cash value as collateral. These loans are not considered taxable income as long as the policy remains in force. Interest accrues on the loan balance, with rates typically ranging from 5% to 8%, which can be fixed or variable depending on the policy and insurer. If the loan and accrued interest are not repaid, the outstanding amount will reduce the death benefit paid to beneficiaries. If the policy lapses or is surrendered with an outstanding loan, the amount exceeding the policy’s cost basis may become taxable income.

Cash withdrawals, also known as partial surrenders, involve directly taking money from the policy’s cash value. Such withdrawals reduce both the policy’s cash value and its death benefit. From a tax perspective, withdrawals are tax-free up to the amount of premiums paid into the policy, which is known as the policy’s cost basis. Any amount withdrawn that exceeds this cost basis is subject to taxation as ordinary income. The Internal Revenue Service (IRS) treats withdrawals as coming from the cost basis first, under a first-in, first-out (FIFO) rule.

Accelerated Benefit Riders

Accelerated benefit riders, sometimes referred to as living benefits, allow policyholders to access a portion of their life insurance policy’s death benefit while they are still alive. The funds received can be used for various purposes, often to cover medical costs or to improve the policyholder’s quality of life.

Access to these benefits is contingent upon meeting specific qualifying conditions. Common triggers include a diagnosis of terminal illness. Another condition is chronic illness, which means the inability to perform a certain number of Activities of Daily Living (ADLs), such as eating, bathing, dressing, continence, toileting, and transferring, or severe cognitive impairment. Additionally, some riders may activate upon the diagnosis of a critical illness, such as a heart attack, stroke, or cancer.

When an accelerated benefit is paid, it represents a percentage of the policy’s death benefit, and the remaining portion is paid to the beneficiaries upon the insured’s death. For tax purposes, these benefits are tax-free if the insured is terminally ill or if the funds are used for qualified long-term care expenses, as per Internal Revenue Code Section 101. However, amounts received for chronic illness that exceed certain IRS per diem limits may be taxable. To initiate a claim, policyholders must submit medical documentation to the insurer for review.

Policy Sales to Third Parties

Selling a life insurance policy to a third party provides another avenue for accessing a lump sum of cash while the insured is still alive. This process involves transferring ownership and beneficiary rights of the policy to an external entity in exchange for an immediate payment. There are two primary types of these transactions: viatical settlements and life settlements.

Viatical settlements are specifically designed for individuals with a terminal illness. In this transaction, the policyholder sells their life insurance policy to a viatical settlement provider for a lump sum, which is less than the death benefit but usually more than the policy’s cash surrender value. These proceeds are tax-free under Internal Revenue Code Section 101 for terminally or chronically ill individuals. The buyer then assumes responsibility for future premium payments and receives the full death benefit upon the insured’s passing.

Life settlements are similar but are for individuals who are older or have a chronic illness but are not necessarily terminally ill. The payout received in a life settlement is higher than the policy’s cash surrender value but less than the full death benefit. The tax implications for life settlements differ from viatical settlements.

The portion of the payout up to the policy’s cost basis is tax-free. Any amount received that exceeds the cost basis but is less than the cash surrender value may be taxed as ordinary income, and any amount above the cash surrender value is treated as capital gains. Both viatical and life settlements involve brokers who represent the policyholder in negotiating with buyers.