Can You Use Your Life Insurance Before You Die?

Life insurance policies can provide financial flexibility beyond their primary role of offering a death benefit. Many policies include features that allow policyholders to access funds or benefits while they are still living. These options can serve various financial needs, from covering unexpected expenses to funding long-term care.

Utilizing Policy Cash Value

Certain types of life insurance policies accumulate a cash value component. Whole life, universal life, and variable universal life insurance are examples of policies that typically build cash value. This cash value grows on a tax-deferred basis.

Policyholders can secure a cash value loan. The policy remains in force during the loan period, and the loan amount, along with accrued interest, reduces the death benefit if not repaid. No strict repayment schedule exists, but interest accumulates. An unpaid loan can eventually cause the policy to lapse if the outstanding amount exceeds the cash value.

Cash value withdrawals are another way to access funds. Unlike a loan, a withdrawal directly reduces the policy’s cash value and can decrease the death benefit proportionally. Withdrawals permanently remove funds from the policy.

Policy surrender allows the policyholder to terminate the policy for its cash surrender value. This value is the accumulated cash value minus any surrender charges or outstanding loans. Surrendering the policy ends all coverage.

Receiving Early Death Benefit Payouts

Policyholders may also access a portion of their policy’s death benefit. This often involves provisions allowing early access to funds, typically when facing significant health challenges or financial needs. These options are distinct from accessing cash value, as they directly draw from the future death benefit.

Accelerated death benefits, also known as living benefits, are provisions allowing early receipt of a portion of the death benefit. These benefits are usually triggered by qualifying conditions such as terminal illness, chronic illness, or critical illness. The specific percentage of the death benefit available varies by policy and insurer.

A viatical settlement involves a terminally ill policyholder selling their life insurance policy. The company pays a lump sum cash amount, which is less than the full death benefit but typically more than the policy’s cash surrender value. The third-party company becomes the new owner and beneficiary, receiving the full death benefit upon the insured’s passing.

Life settlements are similar to viatical settlements but are generally available to policyholders, typically seniors who no longer need or can afford their policy, without being terminally ill. The policyholder sells their policy to a third-party investor. The payment is greater than the cash surrender value but less than the death benefit, and the investor assumes premium payments and becomes the beneficiary.

Understanding Tax Implications

Accessing funds from a life insurance policy before death can have various tax implications depending on the method used. Understanding these tax rules is important for financial planning.

Cash value loans are generally not considered taxable income. However, if a policy lapses with an outstanding loan, the loan amount exceeding the policy’s cost basis (premiums paid) may become taxable as ordinary income. Interest paid on policy loans is typically not tax-deductible.

Cash value withdrawals are generally tax-free up to the amount of premiums paid (cost basis). Any amount withdrawn that exceeds this cost basis is typically taxable as ordinary income.

When a policy is surrendered, any gain realized is subject to ordinary income tax. A gain occurs when the cash surrender value received exceeds the total premiums paid. The taxable amount is the difference between the cash surrender value and the policyholder’s cost basis.

Accelerated death benefits are generally tax-free if the policyholder is certified as terminally or chronically ill. For terminal illness, a physician must certify that death is expected within 24 months. For chronic illness, a licensed healthcare practitioner must certify the individual is unable to perform daily living activities or requires substantial supervision due to cognitive impairment.

The proceeds from a viatical settlement are generally tax-free for terminally ill individuals. This tax exemption applies if the insured is certified by a physician as having an illness or physical condition that can reasonably be expected to result in death within 24 months, as outlined in Internal Revenue Code Section 101(g).

For life settlements, the tax treatment can be more complex. The portion of the proceeds that represents the policyholder’s cost basis (premiums paid) is generally received tax-free. Any amount received above the cost basis but below the cash surrender value may be taxable as ordinary income. The amount exceeding the cash surrender value may be treated as a capital gain.

Impact on the Policy Death Benefit

Each method of accessing funds before death directly impacts the final death benefit paid to beneficiaries. These actions reduce or, in some cases, eliminate the original payout amount.

For cash value loans, any outstanding loan balance, including accrued interest, is deducted from the policy’s death benefit. If the loan causes the policy to lapse before death, no death benefit would be paid.

Cash value withdrawals directly reduce the policy’s face amount or death benefit. The amount withdrawn is permanently removed from the policy. This reduction is irreversible.

Surrendering a life insurance policy eliminates the death benefit entirely. Once the policy is surrendered, it ceases to exist. Consequently, no death benefit will be paid to beneficiaries upon the insured’s death.

When accelerated death benefits are utilized, the amount received is deducted from the policy’s face amount. For example, if a portion of the death benefit is accelerated, the remaining death benefit for beneficiaries will be the original amount minus the accelerated payment.

In both viatical and life settlements, the original beneficiaries receive no death benefit. Since the policy is sold to a third-party company or investor, the new owner becomes the beneficiary. Upon the insured’s death, the new owner receives the full death benefit.