Can You Use Your Life Insurance Money?

Life insurance serves as a financial instrument designed to provide security, with its value often perceived solely as a benefit paid upon the insured’s passing. However, this perspective overlooks the various ways policyholders can access its value during their lifetime. The utility of “life insurance money” extends to both the policyholder and beneficiaries, although the specific methods of utilization are significantly influenced by the type of policy in force. This exploration will delve into how these funds can be accessed and the associated financial considerations.

Accessing Policy Value While Living

Policyholders can access funds from certain life insurance policies during their lifetime, a feature primarily associated with permanent life insurance policies such as whole life, universal life, and variable universal life. Unlike term life insurance, which typically does not accumulate cash value, these permanent policies build a cash value component over time through premium payments. This accumulated cash value can become a financial resource accessible through several mechanisms.

Policy Loans

One common method for accessing accumulated value is through policy loans. A policy loan allows the policyholder to borrow money directly from the insurer, using the policy’s cash value as collateral. These loans typically do not require a credit check and offer flexible repayment terms, meaning there is no strict repayment schedule. However, interest accrues on the loan, and any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if the loan is not repaid before the insured’s death.

Withdrawals

Policyholders may also choose to make withdrawals from their policy’s cash value. Withdrawals directly reduce the cash value and, consequently, the policy’s death benefit. While these withdrawals can provide immediate access to funds, they may be irreversible and can diminish the long-term value and protection offered by the policy. Understand that withdrawing more than the amount of premiums paid can have tax implications.

Surrendering the Policy

Surrendering the policy represents another way to access its value, though it results in the termination of coverage. When a policy is surrendered, the policyholder receives the cash surrender value, which is the accumulated cash value minus any applicable surrender charges or fees. Surrender charges are often higher in the early years of a policy and can significantly reduce the amount received. This action ends the life insurance coverage, meaning no death benefit will be paid to beneficiaries upon the insured’s passing.

Accelerated Death Benefits

Some permanent life insurance policies include accelerated death benefits, also known as living benefits riders. These provisions allow policyholders to access a portion of their death benefit early under specific qualifying circumstances, such as a terminal illness, chronic illness, or critical illness diagnosis. The funds received through accelerated death benefits can help cover medical expenses or other costs during a difficult time. However, receiving these benefits reduces the ultimate death benefit amount paid to the beneficiaries.

Receiving and Using Death Benefits

Upon the death of the insured, beneficiaries initiate the process of receiving life insurance money by filing a claim with the insurance company. This involves notifying the insurer of the policyholder’s passing and providing necessary documentation. Typically, beneficiaries will need to submit a certified copy of the death certificate, the policy number, and their own identification. The insurance company reviews these documents to verify the claim and confirm the beneficiary’s entitlement to the death benefit.

Payout Options

Once the claim is approved, beneficiaries generally have several options for how they can receive the death benefit payout. The most common option is a lump sum payment, where the entire death benefit is paid in a single, direct payment. This provides immediate access to the full amount for the beneficiaries.

Alternatively, beneficiaries can choose to have the funds held by the insurer under an interest accumulation option. In this scenario, the death benefit remains with the insurance company and earns interest until the beneficiary requests payment. This allows the principal to grow while providing flexibility for withdrawal at a later time.

Installment payments offer another structured payout choice. Under this option, the death benefit is disbursed in regular payments over a specified period or, in some cases, for the beneficiary’s lifetime, often referred to as annuitization. While the principal death benefit is typically not taxed, any interest earned on these installment payments may be considered taxable income.

Uses of Death Benefits

Beneficiaries often utilize life insurance death benefits for various financial needs. These funds can be used to cover immediate expenses such as funeral costs and outstanding debts, providing financial relief during a challenging period. The death benefit can also serve as a replacement for the deceased’s lost income, supporting ongoing living expenses for surviving family members. Beneficiaries may also use the funds for significant financial goals, including funding education, making a down payment on a home, or investing for long-term financial security.

Tax Implications of Accessing Funds

Accessing life insurance funds, whether during the policyholder’s lifetime or as a death benefit, carries specific tax implications that warrant careful consideration. The tax treatment varies significantly depending on the method of access and the nature of the funds.

Policy Loans

Policy loans taken against the cash value of a permanent life insurance policy are generally not considered taxable income as long as the policy remains in force. This is because the Internal Revenue Service (IRS) views these funds as a loan against an asset, not as income. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount, up to the gain in the policy, can become taxable income.

Withdrawals

Withdrawals from a policy’s cash value are typically tax-free up to the amount of premiums paid into the policy, which is known as the cost basis. This adheres to the “first-in, first-out” (FIFO) rule, meaning that the IRS assumes the first money withdrawn is a return of the premiums paid. Any amount withdrawn that exceeds the total premiums paid is generally considered taxable income.

Surrendering the Policy

When a policyholder surrenders a life insurance policy for its cash value, the difference between the cash surrender value received and the total premiums paid into the policy (the cost basis) is taxable as ordinary income. For example, if $20,000 was paid in premiums and the surrender value is $30,000, the $10,000 gain is subject to income tax. The insurer may issue a Form 1099-R if the cash surrender value exceeds the premiums paid.

Accelerated Death Benefits

Accelerated death benefits, which allow access to a portion of the death benefit due to terminal or chronic illness, are generally received tax-free. The IRS typically excludes these benefits from gross income if the insured meets the definition of being terminally ill (expected to die within 24 months) or chronically ill and the funds are used for qualified long-term care expenses. However, amounts exceeding certain IRS per diem limits for chronic illness may be taxable.

Death Benefits for Beneficiaries

For beneficiaries, life insurance death benefits are generally received income tax-free. This applies whether the benefit is paid as a lump sum or in installments. However, if the death benefit is held by the insurer and earns interest, any interest accrued on the funds is taxable to the beneficiary.

Estate Tax

While death benefits are typically income tax-free for beneficiaries, they can be subject to federal estate tax if the policy is included in the deceased’s taxable estate and the estate’s value exceeds the federal estate tax exemption threshold. For instance, if the insured owned the policy at the time of death, the death benefit may be included in their gross estate for estate tax purposes. As of 2024, the federal estate tax exemption amount was $13.61 million per individual. Using strategies like an irrevocable life insurance trust can help exclude policy proceeds from the taxable estate.