What Happens to Your Death Benefit After a Partial Payment?

Life insurance policies provide a financial safety net, offering a death benefit to beneficiaries upon the insured’s passing. However, certain types of life insurance offer policyholders the ability to access a portion of their policy’s value during their lifetime. This pre-death access can offer financial flexibility for various needs, but it also directly influences the amount beneficiaries will ultimately receive. Understanding these options is important, as accessing funds impacts the final death benefit and should align with individual financial goals.

Understanding Policy Access Options

Policyholders can access funds from their life insurance policies through several mechanisms before the death benefit is paid out. One common method involves Accelerated Death Benefits (ADBs), which allow access to a portion of the death benefit if the insured faces a qualifying illness. These benefits are typically available for terminal illnesses, often defined as a life expectancy of 24 months or less, or for chronic illnesses where an individual cannot perform a certain number of daily living activities. Some policies may also offer ADBs for critical illnesses like heart attack or cancer.

Another option is taking a policy loan, available with permanent life insurance policies that accumulate cash value. Policyholders can borrow against this cash value, using the policy itself as collateral. These loans often do not require a credit check or a formal application process, offering a flexible source of funds. Repayment terms are flexible, with no strict schedule, though interest accrues on the loan.

Withdrawals from the cash value component of a permanent life insurance policy allow policyholders to take out a portion of their accumulated cash value, which reduces the policy’s cash value and can impact the death benefit. Unlike loans, withdrawals do not need to be repaid. The amount available for withdrawal depends on the policy’s accumulated cash value, which grows over time based on premiums paid and policy performance.

For individuals facing severe health challenges, viatical settlements provide an avenue to sell their life insurance policy to a third party for a lump sum cash payment. This option is for those with a terminal or chronic illness, often with a life expectancy of two years or less. The third-party buyer assumes responsibility for future premium payments and receives the full death benefit when the insured passes away. This differs from a life settlement, which involves selling a policy when the insured is older but not necessarily terminally ill, often over 65 years old. Policyholders pursue life settlements for various reasons, such as no longer needing or affording the policy, or to fund long-term care.

Impact on the Death Benefit

Accessing funds from a life insurance policy during the insured’s lifetime directly affects the death benefit ultimately paid to beneficiaries. When Accelerated Death Benefits (ADBs) are utilized, the amount received is directly subtracted from the policy’s face value or the total death benefit. Any administrative fees or interest associated with the ADB may also reduce the final payout.

Policy loans operate as a lien against the policy’s death benefit. If an outstanding loan balance, including any accrued interest, remains unpaid when the insured dies, that entire amount is deducted from the death benefit paid to the beneficiaries. For example, a $250,000 death benefit with a $50,000 outstanding loan would result in beneficiaries receiving $200,000.

Withdrawals from a policy’s cash value directly reduce the policy’s cash value, and consequently, the death benefit is reduced by the withdrawn amount. Unlike loans, withdrawals are not repaid, so the reduction to the death benefit is permanent.

In the case of viatical and life settlements, the impact on the death benefit is complete. When a policy is sold, ownership transfers entirely to a third party. This means the original death benefit is extinguished for the beneficiaries, as the new owner becomes the sole beneficiary and receives the payout. The insured receives a lump sum payment during their lifetime, but their beneficiaries will receive nothing from that specific policy.

Key Financial and Tax Considerations

Accessing life insurance funds during one’s lifetime carries significant financial and tax implications. For accelerated death benefits, the proceeds are not taxable income if the insured is certified as terminally ill with a life expectancy of 24 months or less. For chronically ill individuals, the proceeds are also tax-free if used for qualified long-term care expenses; otherwise, amounts not used for care may be taxable.

Policy loans are not taxable as income when received because they are considered debt, not income. However, if the policy lapses or is surrendered with an outstanding loan amount that exceeds the policy’s cost basis (the total premiums paid), the gain may become taxable. Interest on policy loans is not tax-deductible.

Withdrawals from a cash value life insurance policy are tax-free up to the amount of premiums paid into the policy, which is considered a return of basis. Any amount withdrawn that exceeds this basis, representing the policy’s earnings, may be taxed as ordinary income. Significant withdrawals can also reduce the cash value to a point where the policy may lapse if premiums are no longer sufficient, triggering further tax liabilities.

Viatical and life settlements have complex tax implications. Viatical settlement proceeds are tax-exempt for terminally ill individuals, as they are treated as an advance on the tax-free death benefit. For life settlements, the proceeds are taxable. The taxable amount is calculated in tiers: proceeds up to the cost basis are tax-free, amounts between the cost basis and cash surrender value are taxed as ordinary income, and any remaining proceeds are taxed as capital gains.

Accessing policy funds can affect future premium payments or increase the risk of policy lapse if the cash value is substantially reduced. Policyholders should understand that specific conditions must be met to qualify for these options. Policyholders should communicate any decisions to access policy funds with beneficiaries, as their expected inheritance will be directly impacted. Consulting with a qualified financial advisor and tax professional is recommended before making any decisions regarding accessing life insurance policy funds.