Whichever way you choose, here's how to understand what's involved in getting your death benefit early.
Accelerated death benefit (and how to know if you qualify)
Medical debt is one of the leading causes of personal bankruptcy, reports the Kaiser Family Foundation. And end-of-life and long-term care are among the most expensive costs for patients and their families. Many struggle to meet those expenses, especially when the patient or family member must stop working or curtail their hours.
Accelerated death benefits allow policy holders living with a terminal diagnosis or a chronic debilitating illness who meet the terms stated in the insurance policy to access their death benefit early.
According to the American Council on Life Insurance Opens in new window, an accelerated death benefit will let you tap between 25% and 95% of your policy's death benefit, though some companies will allow you to get 100%. For this to be an option, you may have to purchase a rider, or you might be obligated to pay a service fee that will be deducted from your death benefit, depending on your life insurance carrier.
Payments come in either installments or as a lump sum, depending on your policy, though some policies let you decide how you'd like to receive the funds. Remember, any payments you get from an accelerated death benefit will reduce the actual death benefit your heirs receive when you die.
Qualifying for an accelerated death benefit depends on your insurance company. Some companies may require that you be unable to perform a certain number of activities of daily living, such as dressing, bathing and feeding yourself, using the bathroom or transferring from a bed to a chair, and are certified as chronically ill from a licensed health care practitioner.
Others may allow you to access the benefit if you have had an organ transplant or are diagnosed with a terminal illness with death expected within 24 months, or if you are permanently confined to a nursing home.
Cashing out with cash value
Other types of insurance let you access funds without needing to show you are suffering from an illness. Whole life, universal life and variable universal life insurance policies have a feature that offers the potential to build up cash value over time that you can eventually access.
It works like this: As you pay your insurance premium on these permanent life policies, a portion goes into a separate cash value account. After several years, this account may have built up. You have several options regarding how to use this money. You can either buy more coverage for a bigger death benefit, pay your premiums, take out a loan or withdraw the funds.
The cash value can be a good source of funding as a way to pay for long-term care or to boost your retirement assets. However, if you choose a withdrawal or a loan that you do not pay back, your death benefit will be lower and there can be tax consequences.
Is a life insurance payout taxable?
In general, accelerated death benefits are not considered taxable income, in the same way that death benefits paid out to your heirs are not taxable. However, there are some nuances. As per IRS rules, if you are terminally ill, you do not need to pay taxes on death benefit.
Likewise, someone who is chronically ill does not need to pay taxes. However, that person must be certified by a licensed healthcare practitioner as chronically ill each year in order to remain exempt from income tax (The amount that can be accessed from one or more policies on an income tax free basis for chronic illness is limited under the tax law).
The rules are a bit more complicated when you're tapping the cash value of a life insurance policy. You do not need to pay income if you take out only up to the amount you put in (you've already been taxed on that amount). And in general, you do not need to pay taxes on any loans you take from your cash value as long as the policy is still in effect.
But you might have a tax liability if your policy lapses before you pay back the loan. You only owe income tax on the gains (your total amount minus what you've paid in). Different rules apply if your policy is classified as a Modified Endowment Contract (MEC).