How to Make Money From Life Insurance Policies

Life insurance policies provide financial protection for beneficiaries after the policyholder’s passing. However, certain policy structures also allow for the accumulation of value that policyholders can access during their lifetime. This transforms a protective measure into an asset, offering financial flexibility. Policyholders can access accumulated funds or even sell a policy.

Cash Value Accumulation

Permanent life insurance policies build cash value, which grows over time, becoming a source of funds for the policyholder. This distinguishes permanent life insurance from term life insurance, which only provides a death benefit for a specific period and does not build cash value. The mechanisms by which cash value grows vary depending on the type of permanent policy.

Whole life insurance features a cash value component that grows at a fixed interest rate set by the insurer. A portion of each premium payment contributes to this cash value, which accumulates on a tax-deferred basis, meaning taxes on the growth are not owed as long as the funds remain within the policy. The cash value is guaranteed to increase. Policyholders of participating whole life policies may also receive dividends, which can further enhance cash value growth.

Universal life insurance offers more flexibility than whole life, allowing policyholders to adjust premiums and death benefits within certain limits. The cash value grows based on an interest rate set by the insurer, which can fluctuate with market conditions but often includes a guaranteed minimum rate. This interest-sensitive growth also benefits from tax deferral. A portion of premiums paid into universal life policies is allocated to the cash value account.

Variable universal life (VUL) insurance provides the most potential for cash value growth, as it allows policyholders to invest the cash value in various sub-accounts, similar to mutual funds. The cash value growth is directly linked to the performance of these underlying investments, offering the potential for higher returns but also carrying market risk. Despite the investment risk, the cash value growth within a VUL policy also benefits from tax deferral. Policyholders can choose their investment strategy based on their risk tolerance.

Utilizing Policy Funds

Policyholders can access the accumulated cash value within their permanent life insurance policies through several methods, providing liquidity during their lifetime without terminating the policy. Understanding the mechanics and tax implications of each method is important for effective financial planning.

One common way to access funds is through a policy loan, using the cash value as collateral. These loans are typically tax-free, and repayment schedules can be flexible, with interest charged on the borrowed amount. If a policy loan is not repaid and the policy lapses or matures, any outstanding loan balance that exceeds the amount of premiums paid (cost basis) can be treated as taxable income by the IRS.

Policyholders can also make direct withdrawals from their cash value. These withdrawals are generally tax-free up to the amount of premiums paid into the policy. Any amount withdrawn that exceeds the cost basis is typically considered taxable income. Withdrawals reduce the policy’s cash value and can lead to a decrease in the death benefit, potentially impacting the financial protection for beneficiaries.

For participating policies, insurers may pay dividends. Dividends are generally not taxable, as they are considered a return of a portion of the premiums paid. Policyholders have several options for using dividends, including taking them as cash, applying them to reduce future premium payments, or reinvesting them to purchase additional paid-up insurance, which increases both the cash value and death benefit. However, if dividends, or interest earned on them, exceed the total premiums paid, the excess may become taxable.

Surrendering a life insurance policy involves canceling the coverage in exchange for its cash surrender value. This value is the accumulated cash value minus any surrender charges or outstanding loans. When a policy is surrendered, any amount received that exceeds the total premiums paid into the policy is considered a taxable gain and is typically taxed as ordinary income. Surrendering the policy terminates the death benefit, removing the financial protection for beneficiaries.

Selling an Existing Policy

Selling an existing life insurance policy to a third party can provide a policyholder with a lump sum of money. This process involves specific types of transactions, each with distinct characteristics and tax implications. Such sales are often considered by individuals who no longer need or can afford their life insurance coverage.

A life settlement involves selling a life insurance policy to a third-party investor for an amount greater than its cash surrender value but less than its death benefit. This option is typically pursued by policyholders who are older or whose health has declined, making the policy more attractive to investors. The process usually involves an appraisal of the policy, followed by offers from investors. The investor assumes responsibility for future premium payments and receives the death benefit upon the insured’s passing.

The tax implications of a life settlement are structured in tiers. The portion of the sale proceeds equal to the policyholder’s cost basis (the total premiums paid) is generally not taxable. Any amount received above the cost basis, up to the policy’s cash surrender value, is taxed as ordinary income. Finally, any proceeds exceeding the cash surrender value are taxed as a capital gain. This tiered taxation applies to policyholders.

A viatical settlement is a specific type of life settlement designed for individuals who are terminally or chronically ill. For a viatical settlement to be considered tax-free under federal law, the insured must typically have a life expectancy of 24 months or less, as certified by a physician. Alternatively, chronically ill individuals who are unable to perform at least two activities of daily living may also qualify for tax-exempt proceeds, provided the funds are used for long-term care expenses.

The favorable tax treatment of viatical settlements stems from federal law, which largely exempts these proceeds from federal income taxation under qualifying conditions. This distinguishes viatical settlements from standard life settlements, where a portion of the proceeds is typically taxable. The tax-free nature of viatical settlements provides financial relief to individuals facing severe health challenges.