How Can You Use Life Insurance While Alive?

While traditionally known for providing a death benefit to beneficiaries, certain life insurance policies also offer accessible value to the policyholder during their lifetime. These “living benefits” extend the policy’s utility beyond its primary function, providing financial support and flexibility for immediate needs or long-term planning.

Accessing Policy Accumulated Value

Certain life insurance policies accumulate cash value from premiums paid, which grows over time. This growth is tax-deferred, meaning taxes are not owed on the gains as they accumulate. Policyholders can access this value through several mechanisms, each with distinct financial implications.

Policyholders can borrow against their cash value through a policy loan, using it as collateral. These loans have interest rates ranging from 5% to 8%. Repayment terms are flexible, often with no fixed schedule, and policyholders can choose to repay at their discretion. However, any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if not repaid before death. A large loan balance could also cause the policy to lapse, potentially leading to a taxable event on accumulated gains.

Cash withdrawals allow policyholders to access a portion of their policy’s cash value. These withdrawals directly reduce the policy’s cash value and the death benefit. Withdrawals are tax-free up to the amount of premiums paid into the policy, which is considered a return of basis. Any amount exceeding the total premiums paid may be subject to ordinary income tax. If the policy is a Modified Endowment Contract (MEC), distributions are taxed differently, with earnings taxed first and potentially subject to a 10% penalty if the policyholder is under age 59½.

Policy surrender involves terminating the life insurance policy in exchange for its cash surrender value. When a policy is surrendered, all coverage, including the death benefit, is forfeited. The cash surrender value is the accumulated cash value minus any surrender charges or outstanding loans. Similar to withdrawals, the amount received is tax-free up to the total premiums paid. Any amount exceeding the premiums paid is considered a gain and is subject to ordinary income tax.

Activating Living Benefit Riders

Living benefit riders are provisions added to certain life insurance policies, allowing policyholders to access a portion of their death benefit while still alive under specific circumstances. These riders provide financial support during challenging health events. They are distinct from accessing the policy’s cash value, as they draw directly from the death benefit amount.

The Accelerated Death Benefit (ADB) rider, also known as a terminal illness rider, allows a policyholder to receive a portion of their death benefit if diagnosed with a terminal illness, typically defined as having a life expectancy of 12 to 24 months or less. Funds can be used for medical expenses, end-of-life arrangements, or other financial needs. Accessing this benefit reduces the death benefit paid to beneficiaries. Accelerated death benefits paid to a terminally ill individual are not subject to federal income tax.

The Chronic Illness rider provides funds if the policyholder becomes chronically ill and cannot perform a certain number of Activities of Daily Living (ADLs), such as bathing, dressing, eating, continence, toileting, and transferring. This rider helps cover long-term care services, whether at home, in an assisted living facility, or a nursing home. Payments used for qualified long-term care expenses are excludable from gross income, up to certain IRS per diem limits. Amounts exceeding these limits may be taxable.

A Critical Illness rider pays a lump sum upon diagnosis of specific critical illnesses, such as a heart attack, stroke, or certain types of cancer. The conditions triggering this benefit are defined within the rider’s terms. The payout can cover medical treatments, recovery costs, or replace lost income. Taxability of critical illness benefits can vary, depending on whether the illness meets the IRS definition of terminal or chronic for tax exclusion.

The Long-Term Care (LTC) rider helps cover long-term care services. This rider provides monthly benefits for a specified period when the policyholder requires assistance with ADLs or experiences cognitive impairment. Benefits can be used for home health care, adult day care, assisted living, or nursing home care. Similar to chronic illness benefits, payments used for qualified long-term care expenses are tax-free up to a daily or periodic limit.

Policy Types Supporting Living Benefits

Accessing living benefits from a life insurance policy is primarily associated with permanent life insurance. These policies build cash value over time, forming the basis for many lifetime benefits. Unlike temporary coverage, permanent policies offer lifelong protection, assuming premiums are paid.

Permanent policies like whole life and universal life accumulate cash value. A portion of each premium contributes to this cash value, which grows tax-deferred. This growth can be accessed through policy loans or withdrawals, and these policies often include living benefit riders.

Whole life insurance is a permanent policy with guaranteed cash value growth, fixed premiums, and a guaranteed death benefit. Its cash value grows at a set, guaranteed rate, providing predictability and stability. This guaranteed growth makes the accumulated value a reliable source for loans or withdrawals.

Universal life insurance offers more flexibility than whole life, allowing policyholders to adjust premium payments and death benefits within limits. Its cash value growth is based on credited interest, which can vary. Variations include Indexed Universal Life (IUL) and Variable Universal Life (VUL).

IUL policies link cash value growth to a stock market index, like the S&P 500, often with caps on gains and floors against losses. VUL policies invest cash value directly in sub-accounts, similar to mutual funds, offering potential for higher returns but carrying market risk. Both IUL and VUL policies offer living benefit riders and access to accumulating cash values.

In contrast, term life insurance policies do not build cash value. They provide coverage for a specific period, or “term,” expiring without accumulated value or payout if the insured outlives the term. Therefore, term life policies do not offer living benefits associated with cash value access or most living benefit riders, as their design focuses solely on providing a death benefit during the specified term.