When and How Can I Use My Life Insurance?

Life insurance is a contract where an insurer pays a sum to beneficiaries upon the insured’s death, providing financial protection for loved ones. While often viewed as a benefit received after death, certain policies also offer financial resources to the policyholder during their lifetime.

Accessing Policy Value While Living

Permanent life insurance policies accumulate cash value, which policyholders can access during their lifetime. Policy loans are a common method, using the cash value as collateral. Loans accrue interest (5-8%), often lower than personal loans or credit cards. While there is no strict repayment schedule, any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if not repaid.

Cash value withdrawals are another option. These withdrawals reduce both the cash value and the policy’s death benefit. Withdrawals are tax-free up to premiums paid (return of cost basis). Amounts withdrawn exceeding the premiums paid are taxable as ordinary income.

Policy surrender terminates the contract for its cash surrender value. This value is the accumulated cash value minus surrender charges and outstanding loans. Surrender charges start high in early years and decrease over time, phasing out after 10 to 15 years. Surrendering the policy ends coverage, meaning no death benefit will be paid to beneficiaries.

Accelerated death benefits (living benefits riders) allow early access to a portion of the death benefit under specific circumstances. These include terminal, chronic, or critical illness. A terminal illness rider permits access with a 12-24 month life expectancy. A chronic illness rider may be triggered by inability to perform daily living activities (ADLs) or severe cognitive impairment. The funds received through these riders reduce the eventual death benefit paid to beneficiaries.

Receiving the Death Benefit After Death

Beneficiaries must initiate the claim process after an insured person passes away. This first step involves notifying the insurance company, either directly or through an agent.

Documentation is required to support the claim. A certified death certificate is required. The policy number and an insurer-provided claim form are also necessary. Providing accurate and complete information helps to prevent delays in processing the claim.

After submission, the insurance company reviews the claim for validity. The process takes 14 to 60 days from paperwork receipt. Delays can occur if information is missing or if the death happened within the policy’s contestability period (usually the first two years), which allows the insurer to investigate.

Beneficiaries have several options for how they can receive the death benefit:
Lump-sum payment: The entire death benefit is paid out at once.
Interest income: The insurer holds the principal and pays interest to the beneficiary.
Fixed period and fixed amount installments: Regular payments are provided over a set duration or until the benefit is exhausted.
Life income option: Guaranteed payments are provided for the beneficiary’s lifetime, with the amount determined by factors like age and gender.

Financial Implications of Accessing Life Insurance

Accessing life insurance value carries specific tax implications. The death benefit paid to beneficiaries is exempt from federal income tax. However, if beneficiaries delay the payout and leave funds with the insurer in an interest-bearing account, any interest earned may be taxable.

Policy loans are not considered taxable income as long as the policy remains active. A loan is viewed as borrowing against collateral, not a distribution of gains. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount, up to the policy’s gain, can become taxable income.

Cash value withdrawals are tax-free up to premiums paid (return of cost basis). Any portion exceeding total premiums paid is taxable as ordinary income. This is because earnings within the policy grow tax-deferred and become taxable upon withdrawal if they exceed the original investment.

Surrendering a life insurance policy for its cash value can be a taxable event. If the cash surrender value exceeds total premiums paid, the difference is a taxable gain. This gain represents the accumulated earnings that have not yet been taxed.

Accessing cash value or accelerated death benefits impacts the ultimate death benefit. Policy loans, cash value withdrawals, and accelerated death benefit payouts reduce the death benefit. Outstanding loan balances are subtracted from the death benefit if not repaid. Funds from withdrawals or accelerated benefits also directly decrease the payout. Policyholders should consult with a tax professional to understand the specific tax consequences related to their individual situation.