How Can You Use Your Life Insurance While Alive?

Life insurance provides a financial safeguard for beneficiaries after a policyholder’s passing. However, certain types of life insurance, particularly permanent policies, offer features that extend their utility beyond this traditional role. These policies can become a valuable financial resource for the policyholder during their lifetime, providing avenues to access funds for various needs. This living benefit aspect transforms a life insurance policy into a dynamic financial tool, capable of offering support and flexibility when it is most needed.

Accessing Your Policy’s Cash Value

Permanent life insurance policies, such as whole life and universal life, build cash value over time, distinct from the death benefit. This cash value grows on a tax-deferred basis. Policyholders can access this accumulated cash value through policy loans, cash withdrawals, or by surrendering the policy.

Policyholders can borrow against their policy’s cash value. The cash value acts as collateral for this loan from the insurer. Policy loans are generally not taxable if the policy remains in force and the loan amount does not exceed premiums paid into the policy. Interest accrues on the outstanding balance, and while repayment is not strictly mandatory, any unpaid loan will reduce the death benefit. If the policy lapses or is surrendered with an outstanding loan, the policyholder may face tax consequences on any gain in the policy.

Cash withdrawals can be made from the policy’s cash value. Policyholders can withdraw up to their “basis,” typically the total premiums paid, without incurring taxes. Amounts exceeding this basis are generally subject to income tax at ordinary income rates. It is important to consider that withdrawals directly reduce both the policy’s cash value and its death benefit. Excessive withdrawals can lead to the policy lapsing if the remaining cash value is insufficient to cover ongoing costs.

Policy surrender terminates life insurance coverage in exchange for the policy’s cash surrender value. This value is the accumulated cash value minus any surrender charges and outstanding policy loans. Surrendering the policy ends all coverage, meaning no death benefit will be paid to beneficiaries upon the policyholder’s passing. If the cash surrender value exceeds total premiums paid, this excess is considered a taxable gain and is taxed as ordinary income. Surrender charges, which can be significant, particularly in the initial years of the policy, further reduce the payout.

Utilizing Accelerated Death Benefits

Accelerated Death Benefits (ADBs), also known as living benefits, allow policyholders to access a portion of their life insurance death benefit while still alive, under specific qualifying circumstances. These benefits are typically available as riders or provisions within a policy, designed to offer financial relief when facing severe health challenges. ADBs help cover significant medical expenses, long-term care costs, or other living expenses during difficult periods.

Eligibility for ADBs generally hinges on meeting specific medical criteria. Common triggers include a diagnosis of terminal illness, typically defined as having a life expectancy of 12 to 24 months or less, as certified by a physician. Another qualifying condition is chronic illness, which often means the policyholder is unable to perform at least two of six Activities of Daily Living (ADLs) without substantial assistance for 90 days, or requires substantial supervision due to severe cognitive impairment. Some policies also offer ADBs for specific critical illnesses like heart attack, stroke, or cancer.

When an ADB is utilized, the amount received is an advance on the policy’s death benefit, directly reducing the sum that will eventually be paid to beneficiaries. The percentage accessible typically ranges from 25% to 100%, depending on the insurer and policy terms. Under current tax laws, accelerated death benefits are generally excluded from gross income and are not taxable, provided certain conditions are met, such as the policyholder being certified as terminally or chronically ill. However, if chronic illness benefits exceed IRS per diem limits and are not used for qualified long-term care expenses, or if interest is paid on the advanced amount, a portion may become taxable.

Selling Your Life Insurance Policy

Selling a life insurance policy to a third party represents another avenue for policyholders to access its value during their lifetime. This process involves transferring ownership in exchange for a lump sum payment, offering an option for those who no longer need or can afford their coverage. The two primary types of policy sales are viatical settlements and life settlements, each catering to different circumstances.

Viatical settlements involve the sale of a life insurance policy by a policyholder who is terminally or chronically ill. A third-party buyer, typically a viatical settlement provider, purchases the policy for a cash sum. This payment is generally more than the policy’s cash surrender value but less than the full death benefit. The buyer assumes responsibility for future premiums and becomes the new beneficiary, receiving the death benefit upon the insured’s passing. For policyholders certified as terminally ill with a life expectancy of 24 months or less, proceeds from a viatical settlement are generally tax-free under federal law, as they are considered an advance on the death benefit.

Life settlements involve the sale of a life insurance policy by a policyholder who is typically older, often aged 65 or above, or has declining health, but is not terminally ill. The process mirrors viatical settlements, where a third-party investor buys the policy for a lump sum that exceeds the cash surrender value but is less than the death benefit. The investor takes over premium payments and collects the death benefit.

Unlike viatical settlements, the tax treatment of life settlement proceeds is more complex. The proceeds are generally taxed in tiers: The portion equal to the policyholder’s cost basis (total premiums paid) is tax-free. Amounts above the cost basis up to the cash surrender value are taxed as ordinary income. Any remaining proceeds exceeding both the cost basis and cash surrender value are taxed as capital gains.

The decision to sell a life insurance policy means the original beneficiaries will not receive the death benefit. Policyholders should understand the implications and potential tax consequences before proceeding with a sale.