How to Utilize Life Insurance While Alive

Life insurance, traditionally viewed as a financial safeguard for beneficiaries, offers a range of benefits accessible during one’s lifetime. These “living benefits” transform a policy into a versatile financial tool, providing liquidity and support for various needs. Understanding these options allows policyholders to leverage their insurance for immediate financial solutions, addressing unexpected expenses or long-term care requirements.

Accessing Policy Cash Value

Permanent life insurance policies, such as whole life or universal life, accumulate a cash value component over time that grows on a tax-deferred basis. This cash value can be accessed by the policyholder while they are still alive through several methods, each with specific mechanics and potential tax implications.

Policy Loans

Policyholders can borrow against their policy’s cash value, using it as collateral. These loans are generally not considered taxable income, provided the policy remains in force. If the policy lapses or is surrendered with an outstanding loan, the borrowed amount, to the extent it exceeds premiums paid, may become taxable as ordinary income. Interest accrues on policy loans, and any unpaid balance will reduce the death benefit. This interest is typically not tax-deductible. An exception arises if the policy is classified as a Modified Endowment Contract (MEC) under IRS rules. For MECs, loans are taxed as ordinary income to the extent of any gain, and a 10% penalty may apply if the policyholder is under age 59½.

Partial Withdrawals

Policyholders can withdraw a portion of their cash value directly. Withdrawals are generally tax-free up to the amount of premiums paid into the policy, which is considered a return of cost basis. Any amount withdrawn exceeding premiums paid is typically taxed as ordinary income. Partial withdrawals reduce the policy’s cash value and can also lead to a reduction in the death benefit. Some policies may impose surrender charges even on partial withdrawals.

Surrendering the Policy

A policyholder can choose to surrender the entire policy to receive its cash surrender value. Surrendering the policy means terminating coverage entirely. The cash surrender value is the accumulated cash value minus any applicable surrender charges and outstanding loans. If the cash surrender value received exceeds the total premiums paid, the excess amount is generally taxable as ordinary income. This action results in the complete loss of life insurance coverage and the death benefit for beneficiaries. Surrender charges can be substantial, especially if the policy is surrendered in its early years.

Utilizing Living Benefit Riders

Many life insurance policies offer optional living benefit riders. These riders allow policyholders to access a portion of their policy’s death benefit while still alive, typically under specific qualifying health circumstances. Using these riders reduces the eventual death benefit paid to beneficiaries.

Accelerated Death Benefit (ADB) Rider

The Accelerated Death Benefit (ADB) rider, sometimes referred to as terminal, chronic, or critical illness riders, allows a policyholder to receive a portion of their death benefit if diagnosed with a qualifying severe health condition. For instance, a terminal illness diagnosis, often defined as having a life expectancy of 24 months or less, can trigger these benefits. Critical illness riders activate upon diagnosis of specific conditions like cancer, heart attack, or stroke. Benefits received under an ADB rider for terminal illness are generally tax-free under federal law. For chronically ill individuals, benefits may also be tax-free if used for qualified long-term care expenses. Receiving these benefits may impact eligibility for certain government assistance programs.

Long-Term Care (LTC) Riders

Long-Term Care (LTC) riders allow policyholders to use a portion of their death benefit to cover qualified long-term care expenses, such as nursing home care, assisted living, or in-home care. Activation typically requires certification that the policyholder is chronically ill and unable to perform a certain number of Activities of Daily Living (ADLs), like bathing or dressing. The benefit is often paid as a monthly amount, which is then deducted from the policy’s death benefit. The tax treatment of benefits from qualified LTC riders is generally favorable, with payments intended to be tax-free up to certain per diem limits for qualified long-term care services. Any benefits received in excess of the annually adjusted limit may be taxable.

Selling Your Policy

An alternative way to access value from a life insurance policy while alive is by selling it to a third party. This process involves a complete transfer of policy ownership. The financial proceeds received from selling a policy are typically higher than the cash surrender value offered by the insurer.

Viatical Settlement

For individuals with a terminal illness, a viatical settlement offers an avenue to sell their life insurance policy. A policyholder with a life expectancy typically of 24 months or less sells their policy to a third-party buyer. The buyer provides a lump sum payment, which is less than the death benefit but more than the policy’s cash surrender value. The buyer then becomes the new owner and beneficiary, assuming responsibility for future premium payments and receiving the full death benefit upon the insured’s passing. Viatical settlements are generally not taxable under federal law for terminally ill individuals. Payouts commonly range from 50% to 80% of the policy’s death benefit.

Life Settlement

For policyholders who are not terminally ill but may be older, typically aged 65 or older, or have a chronic illness, a life settlement provides a similar option. This involves selling an existing life insurance policy to a third-party investor for a lump sum. The amount received is typically more than the cash surrender value but less than the death benefit. The investor takes over premium payments and collects the death benefit when the insured dies. Life settlements are subject to a tiered tax treatment. Proceeds up to the policyholder’s cost basis are generally tax-free. Any proceeds exceeding the cost basis but within the policy’s cash surrender value are taxed as ordinary income. Any amount received above the cash surrender value is taxed as a long-term capital gain. Typical payouts range from 10% to 25% of the policy’s face value.