What Life Insurance Can You Use While Alive?

Life insurance traditionally provides a death benefit to beneficiaries after an individual’s passing. Modern life insurance policies, however, extend beyond this singular purpose, offering financial flexibility and access to funds during the policyholder’s lifetime. These policies address various financial needs, such as medical expenses, educational funding, or supplementing retirement income. The ability to utilize life insurance while alive stems from policy structures and features that allow access to accumulated value or portions of the death benefit. This provides a financial tool that adapts to evolving life stages and unforeseen challenges.

Types of Policies with Living Benefits

Certain life insurance policies incorporate a cash value component that accumulates over time, enabling access to funds while living. This cash value grows tax-deferred, distinguishing these policies from term life insurance, which does not build cash value. Cash value accumulation varies among permanent life insurance options, each designed to meet distinct financial objectives.

Whole Life Insurance

Whole life insurance offers a guaranteed death benefit, fixed premiums, and a cash value that grows at a predictable interest rate. A portion of each premium payment is allocated to this cash value, growing steadily over the policy’s lifetime. This guaranteed growth provides a reliable source of funds, offering a stable financial asset unaffected by market fluctuations. Policies from mutual insurers may also earn dividends, which can increase cash value or reduce premiums.

Universal Life (UL) Insurance

Universal life (UL) insurance provides greater flexibility in premiums and death benefits compared to whole life policies. Its cash value grows based on an interest rate declared by the insurer, which may adjust periodically but often includes a guaranteed minimum rate. Policyholders can adjust premium payments; payments exceeding the cost of insurance contribute to the cash value, allowing faster accumulation. This flexibility benefits individuals with fluctuating incomes.

Indexed Universal Life (IUL) Insurance

Indexed universal life (IUL) insurance links its cash value growth to a market index, without direct investment. While offering potential for higher returns than traditional universal life, IUL policies include a “cap” on the maximum interest rate and a “floor” that guarantees a minimum return, protecting against market downturns. The cash value grows tax-deferred, and a participation rate determines the percentage of the index’s gain credited to the policy.

Variable Universal Life (VUL) Insurance

Variable universal life (VUL) insurance ties its cash value growth to the performance of underlying investment sub-accounts chosen by the policyholder. These sub-accounts operate like mutual funds, exposing the cash value to market risk and potential gains or losses. This policy offers the highest potential for cash value accumulation but also carries the greatest risk, as cash value can decrease with poor investment performance. Like other universal life policies, VUL offers flexible premiums and death benefits.

The cash value component in these permanent life insurance policies serves as a financial resource. It allows policyholders to build wealth tax-deferred while maintaining life insurance coverage. The accessibility of this accumulated value is a primary reason these policies are considered living benefits, providing funds for various needs during one’s lifetime.

Accessing Policy Value While Alive

Policyholders can access accumulated cash value within permanent life insurance policies through policy loans, withdrawals, and policy surrender. These methods offer different levels of access and have varying implications for the policy’s death benefit and future performance. Understanding these distinctions is important for financial planning.

Policy Loans

Policy loans allow policyholders to borrow against their cash value, using the policy as collateral. These loans are not considered withdrawals, meaning the cash value continues to grow, potentially earning interest or investment gains. Policy loans do not require a credit check and often have more flexible repayment schedules than traditional bank loans. Interest accrues on the loan balance. While repayment is not mandatory during the policyholder’s lifetime, any outstanding loan balance, plus accrued interest, will reduce the death benefit paid to beneficiaries.

Withdrawals

Withdrawals, also known as partial surrenders, involve taking funds from the policy’s cash value. Unlike loans, withdrawals permanently reduce both the cash value and the policy’s death benefit, and the amount withdrawn is not expected to be repaid. Withdrawals are tax-free up to the amount of premiums paid into the policy, known as the cost basis. Any amount withdrawn exceeding this cost basis is considered taxable income. This method suits smaller, immediate financial needs without repayment.

Policy Surrender

Policy surrender involves terminating the life insurance contract in exchange for its cash surrender value. This option provides access to the largest sum of the accumulated value. The cash surrender value is the policy’s accumulated cash value minus any surrender charges, which can be significant, especially in early years. Surrendering the policy eliminates the death benefit, meaning beneficiaries receive no payout upon the policyholder’s death. Any gain realized upon surrender, which is the cash surrender value exceeding total premiums paid, is taxable as ordinary income.

These methods of accessing policy value are distinct from accelerated death benefits, which are triggered by specific health events. Policy loans, withdrawals, and surrenders serve as flexible financial tools for general liquidity needs, allowing policyholders to leverage their policy’s accumulated value during their lifetime. Each option carries specific financial and tax implications that should be considered based on individual circumstances.

Accelerated Death Benefits

Beyond accessing accumulated cash value, life insurance policies offer living benefits through accelerated death benefit riders. These features allow policyholders to receive a portion of their death benefit while alive under specific health circumstances. Such riders provide financial relief when facing severe illness, reducing financial strain associated with medical care or end-of-life expenses. Accessing these benefits reduces the death benefit paid to beneficiaries.

Critical Illness Rider

A common accelerated death benefit is the critical illness rider. This rider pays a lump sum upon diagnosis of a predefined severe medical condition, such as a heart attack, stroke, or cancer. The funds can be used for any purpose, including covering medical bills, adapting a home for accessibility, or replacing lost income due to inability to work. The specific conditions that qualify for a payout are defined within the policy contract.

Chronic Illness Rider

The chronic illness rider provides access to a portion of the death benefit if the policyholder is unable to perform a certain number of Activities of Daily Living (ADLs), such as bathing or dressing, or experiences severe cognitive impairment. These funds help cover the costs of long-term care services, whether at home, in an assisted living facility, or a nursing home. This rider helps alleviate the financial burden associated with extended care needs.

Terminal Illness Rider

A terminal illness rider allows policyholders to receive a payout if diagnosed with a limited life expectancy, certified by a physician. These funds can be used without restriction, offering financial flexibility during a difficult time. Policyholders might use the funds for experimental treatments, end-of-life care expenses, or to fulfill final wishes and provide for their family’s immediate needs. This benefit provides peace of mind in challenging circumstances.

Availability and specific triggers for these accelerated death benefit riders vary by policy and insurer. While these riders provide financial access during severe health crises, they directly reduce the death benefit paid to beneficiaries. These benefits are distinct from accessing cash value for general financial needs, addressing severe health-related events.

Tax Considerations for Living Benefits

Accessing life insurance benefits while alive involves tax implications policyholders should understand. Tax treatment differs depending on the method of access: policy loans, withdrawals, policy surrender, or accelerated death benefits. Understanding helps maximize financial utility and minimize unexpected tax liabilities.

Policy Loans (Tax)

Policy loans are not considered taxable income when taken, provided the policy remains in force. The IRS does not view a loan as a distribution of policy earnings but as a debt against the policy’s cash value. However, tax consequences can arise if the policy lapses or is surrendered with an outstanding loan balance. In such cases, any portion of the loan exceeding total premiums paid (cost basis) may be considered taxable income. Additionally, if the policy is classified as a Modified Endowment Contract (MEC), loans are treated as taxable distributions to the extent of policy gains, potentially incurring a 10% penalty if the policyholder is under age 59½.

Withdrawals (Tax)

Withdrawals from a life insurance policy’s cash value are tax-free up to the amount of premiums paid into the policy, which represents the policyholder’s cost basis. This is because these amounts are considered a return of the policyholder’s principal investment. However, any amount withdrawn exceeding this cost basis is taxable as ordinary income. Withdrawals also reduce the policy’s cash value and death benefit.

Policy Surrender (Tax)

Surrendering a life insurance policy for its cash surrender value results in a taxable event if the amount received exceeds total premiums paid. This gain is taxed as ordinary income, not as a capital gain, because surrender is considered a termination of the contract rather than a sale or exchange. Surrender charges, deducted from the cash value, can also impact the net amount received.

Accelerated Death Benefits (Tax)

Accelerated death benefits, paid out under critical, chronic, or terminal illness riders, are received tax-free under current IRS rules. To qualify for this tax-free treatment, specific conditions must be met, such as certification as terminally ill or chronically ill and unable to perform a certain number of ADLs. These benefits are treated similarly to the tax-free nature of a death benefit, providing financial relief without additional tax burdens during a health crisis.

Tax laws related to life insurance are intricate and subject to change. Consulting with a qualified tax professional is advisable to understand specific implications for an individual’s financial situation before accessing any living benefits.