What Life Insurance Can You Use While Alive?

Life insurance is known for providing a financial safety net to beneficiaries after the policyholder’s death. However, certain policies offer “living benefits” that can be accessed during one’s lifetime to address financial or health-related challenges. Not all life insurance policies include these benefits, so understanding the distinctions is important. Accessing funds or benefits from a life insurance policy prior to death can offer significant financial flexibility and peace of mind.

Understanding Policies with Living Benefits

Life insurance policies with living benefits typically fall under permanent life insurance, including whole life, universal life, and variable universal life. Unlike term life insurance, which covers a specific period, permanent policies offer lifelong coverage. A defining characteristic of permanent life insurance is its cash value component, which accumulates over time.

A portion of each premium payment is allocated to this cash value account, growing on a tax-deferred basis. This cash value is a savings or investment feature that can accrue interest or market returns, depending on the policy type. For instance, whole life policies often have a guaranteed interest rate, while universal and variable universal life policies may offer growth tied to market performance or specific investment options.

The cash value serves as a financial asset within the policy, providing funds the policyholder can access. Many living benefits are also offered through “riders,” which are optional provisions added to a standard life insurance contract. These riders enable policyholders to access portions of their death benefit under specific circumstances, such as a serious illness.

Accessing Policy Cash Value

Policyholders can access the accumulated cash value in permanent life insurance policies through several methods, each with distinct financial and tax implications. One common approach is taking a policy loan, where the policyholder borrows against the available cash value. These loans typically offer lower interest rates than conventional loans and can be repaid at the policyholder’s convenience. Any outstanding loan balance and accrued interest will reduce the death benefit paid to beneficiaries. Policy loans are generally not considered taxable income, provided the policy does not lapse with an outstanding loan.

Another method is making a withdrawal from the policy’s cash value. Withdrawals can be taken without interest charges, but they directly reduce the policy’s cash value and the death benefit. For tax purposes, withdrawals are generally treated on a “first-in, first-out” (FIFO) basis, meaning the portion representing premiums paid is typically tax-free. Any amount withdrawn that exceeds the total premiums paid is usually considered taxable income.

The third method is surrendering the policy, which involves canceling the life insurance contract and receiving the net cash surrender value. This net value is the accumulated cash value minus any outstanding loans, interest, and potential surrender charges, which can be substantial in the early years. When a policy is surrendered, any amount received that exceeds the total premiums paid is considered taxable income at ordinary rates.

It is also important to consider Modified Endowment Contracts (MECs). If a life insurance policy becomes an MEC due to excessive premiums paid within a certain period, the tax treatment of loans and withdrawals changes. Distributions from an MEC are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are taxed first. Withdrawals or loans may be subject to a 10% penalty if taken before age 59½, similar to qualified retirement plans. Consulting a financial or tax professional is advisable before accessing cash value to understand the specific tax implications.

Utilizing Accelerated Death Benefit Riders

Accelerated Death Benefit (ADB) riders, also known as living benefits, allow policyholders to access a portion of their life insurance policy’s death benefit while still alive. These riders are triggered by specific health-related circumstances and provide financial relief during difficult times. The amount received from an ADB rider generally reduces the death benefit paid to beneficiaries.

Common triggers for ADBs include terminal illness, chronic illness, and critical illness. A terminal illness diagnosis means a medical professional certifies the policyholder has a limited life expectancy, often 12 to 24 months or less. In such cases, a portion or the entirety of the death benefit can be paid out in a lump sum for medical expenses, end-of-life care, or other financial needs.

A chronic illness trigger usually applies when the policyholder is unable to perform a specified number of Activities of Daily Living (ADLs) or has severe cognitive impairment. Common ADLs include:

• Bathing
• Dressing
• Eating
• Continence
• Toileting
• Transferring

The inability to perform two out of six ADLs is a common criterion. Benefits for chronic illness are often paid monthly to cover long-term care costs.

Critical illness riders provide a lump-sum payment if the policyholder is diagnosed with a specific serious illness listed in the policy, such as a heart attack, stroke, or certain types of cancer. These conditions do not necessarily have to be terminal. The payout can help cover medical expenses, lost income, or other costs associated with the illness, allowing the policyholder to focus on recovery.

Long-Term Care Coverage through Life Insurance

Life insurance policies can also serve as a source of long-term care (LTC) coverage, offering financial support for services needed due to chronic illness, disability, or cognitive impairment. This can be achieved through a dedicated long-term care rider or by purchasing a hybrid life insurance/LTC policy. These options differ from general accelerated death benefits by focusing specifically on long-term care costs.

Benefits are typically triggered when the policyholder is certified by a healthcare professional as unable to perform a certain number of Activities of Daily Living (ADLs) or if they have severe cognitive impairment. Most policies require the inability to perform at least two ADLs to qualify for benefits. The benefits are commonly structured as monthly payments, which can be a set percentage of the death benefit, and are paid until a lifetime limit is reached or the death benefit is exhausted.

This integration of LTC coverage within a life insurance policy offers a dual purpose: providing a death benefit for beneficiaries if LTC is not needed, or providing funds for care if it is. The funds from an LTC rider can be used for various care settings, including home health care, assisted living facilities, or nursing homes. While adding an LTC rider usually comes with an additional cost, it can be a more affordable alternative than a standalone long-term care policy and helps protect personal assets from the high costs of extended care.