How Does Life Insurance Work While You’re Alive?

Life insurance primarily provides a death benefit to beneficiaries upon the policyholder’s passing. However, certain policies offer “living benefits” that can be accessed during the policyholder’s lifetime. These features make life insurance a versatile asset, providing financial flexibility for various needs and emergencies.

Understanding Policy Cash Value

Many living benefits in life insurance are enabled by the policy’s cash value. This savings or investment component accumulates within permanent life insurance policies like whole life, universal life, and variable universal life. It grows over time, separate from the death benefit.

A portion of each premium payment, after covering costs, is allocated to this cash value. This accumulation grows on a tax-deferred basis, meaning earnings are not taxed until withdrawn. Growth depends on the policy type, with some offering guaranteed interest rates and others linking to market performance or dividends.

Cash value distinguishes permanent life insurance from term life, which typically does not build cash value. As it grows, cash value becomes a significant financial resource accessible for various purposes.

Accessing Policy Value During Life

Policyholders can access accumulated cash value from permanent life insurance policies through several methods, each with distinct implications. These options allow individuals to tap into their policy’s value without necessarily terminating coverage.

Policy loans allow policyholders to borrow funds from the insurer, using cash value as collateral. These loans do not require credit checks and typically carry an interest rate. They are generally tax-free if the policy remains in force and is not a Modified Endowment Contract (MEC). Unpaid loans, including interest, reduce the death benefit.

Withdrawals from cash value directly reduce the policy’s cash value and can also decrease the death benefit. Tax-wise, withdrawals are generally tax-free up to the amount of premiums paid (cost basis). Any amount exceeding this cost basis is typically considered taxable income.

Policyholders can also surrender, or cancel, their policy to receive the cash surrender value. This is the cash value minus any surrender charges and outstanding loans. Surrendering terminates coverage and the death benefit. Any gain (cash value received minus premiums paid) is subject to ordinary income tax. Surrender charges can be substantial early on, declining over 10 to 20 years.

Living Benefit Provisions

Beyond cash value access, many life insurance policies offer living benefit provisions, often as riders. These allow policyholders to access a portion of their death benefit under specific qualifying circumstances while alive. Riders are optional additions providing extra benefits, typically for an additional cost, designed for financial relief during health crises.

Accelerated Death Benefit (ADB) riders are a common type of living benefit. One such rider is for terminal illness, allowing access to a percentage of the death benefit if the policyholder is diagnosed with a condition that gives them a limited life expectancy, often 12 to 24 months. This can help cover medical expenses or provide financial support during a difficult time.

Another type is the chronic illness rider, which provides access to funds if the policyholder becomes unable to perform a certain number of Activities of Daily Living (ADLs), typically two out of six, or experiences severe cognitive impairment requiring substantial supervision. The six standard ADLs include bathing, dressing, eating, toileting, transferring (moving in and out of a bed or chair), and continence. Funds from this rider can be used for long-term care costs, such as nursing home care, assisted living, or in-home health services.

Critical illness riders provide a payout upon diagnosis of specific severe conditions like heart attack, stroke, or certain cancers. These funds help cover unexpected medical bills, lost income, or other expenses. Accessing funds through any living benefit rider reduces the ultimate death benefit paid to beneficiaries.

Policy Structures and Living Benefits

The availability of living benefits largely depends on the policy structure. Permanent life insurance policies generally offer cash value accumulation and living benefit riders. These policies provide coverage for the policyholder’s entire life, assuming premiums are paid.

Whole life insurance, a permanent coverage, offers guaranteed cash value growth at a fixed interest rate and fixed premiums. This predictability makes it a stable option for those seeking guaranteed cash value access and the option to add living benefit riders.

Universal life (UL) insurance provides more flexibility regarding premium payments and death benefits. Its cash value growth is typically tied to interest rates declared by the insurer, often with a guaranteed minimum rate. This flexibility allows policyholders to adjust payments, potentially using accumulated cash value to cover premiums, though careful management is necessary to prevent policy lapse.

Variable universal life (VUL) insurance offers the potential for higher cash value growth by allowing policyholders to invest the cash value in various sub-accounts, similar to mutual funds. While this provides greater control and growth potential, it also introduces market risk, meaning the cash value can fluctuate and even decrease based on investment performance. Despite this risk, VUL policies also include living benefit features.

In contrast, term life insurance covers a specific period and does not build cash value. Therefore, term policies do not offer the same living benefits or cash value access as permanent policies. While some term policies may include limited accelerated death benefit riders, they lack the robust cash value components of permanent life insurance that enable loans, withdrawals, or surrender options. Rider availability and terms vary among insurers.