What Does Liquidity Refer to in a Life Insurance Policy?

Life Insurance Liquidity Explained

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A life insurance policy’s liquidity refers to how easy it is for someone to draw funds from a policy. Here’s what you should know about how that process works, who it benefits, and why it matters.

Key Takeaways

  • Liquidity refers to how effortlessly you can convert an asset into cash. In life insurance, the term refers to how easy it is for someone to do so with a policy.
  • Policyholders can use direct withdrawals or loans to access the cash value in their permanent policies during an insured person’s life.
  • Accelerated death benefit riders can provide additional liquidity. 
  • Life insurance plans provide beneficiaries liquidity upon the insured person’s death, potentially covering necessary living expenses or funeral costs for the deceased.
  • Businesses can use the liquidity from life insurance proceeds to cover operating expenses, hire new officers, or restructure the company when an insured leader passes away.

What Is Liquidity in Life Insurance?

Liquidity in life insurance policies relates to how quickly and easily someone can convert a policy into cash, either during the insured person’s life or after they’ve passed. It can apply to the accessibility of funds for both policyholders and beneficiaries.

In general, all types of life insurance policies should supply a liquid payout to beneficiaries after the insured party passes away. However, some policies also offer liquidity during the policyholder’s life—they’re known as “living benefits” because you can access the policy’s cash value or, in some cases, the death benefit while you’re alive. These types of policies are:

  • Life insurance policies with a cash value
  • Policies with one or more accelerated death benefit riders for living benefits

Riders are additional conditions you can add to an insurance contract. Riders that accelerate the death benefit (if conditions are met) are frequently free of charge. 

Generally, only permanent life insurance policies have cash values, and therefore, can be liquidated. These policies cover the insured for their entire life, so long as the policyholder makes timely payments.

If you have a permanent life insurance policy, part of your monthly premium accumulates within the policy and grows tax-deferred. That becomes the policy’s cash value, which may count as an asset for some purposes. It may also be possible for you to use your policy’s cash value and death benefit as collateral for a secured loan.

In contrast, term life insurance policies only cover the insured for a predetermined period, such as five, 10, or 20 years or up to a certain age. These policies generally don’t allow for cash value to accumulate, but some insurers allow you to add living benefit riders that provide liquidity during the insured’s life. 

How Policyholders Benefit From Liquidity

Besides the peace of mind that comes from knowing your beneficiaries will be well taken care of in the future, you can benefit from the liquidity of your policy during your lifetime. There are two ways to access a policy's liquidity while you’re alive: tapping into its cash value and taking an advance on the death benefit. Here’s how it works in each case.

Cash Value

If you own a permanent life insurance policy with a cash value, you can generate liquidity during your life by taking a withdrawal or borrowing the cash value as a loan. Typically, a withdrawal that exceeds the amount you’ve paid into the cash value through your premiums is taxable.

For example, say you’ve held a policy for 15 years, and it has a cash value of $125,000. You contributed $100,000 directly, and $25,000 is due to growth. If you withdraw $115,000, the $15,000 from asset growth is taxable.

If you withdraw the entire cash value of your account, your insurance company could also cancel the policy altogether and your coverage would end.

If you borrow against your cash value, you generally won’t pay taxes on the proceeds. There won’t be a set repayment term either, though interest still accrues and is added to the loan principal. If you don’t pay back the loan in full before the insured person’s death, the death benefit will be reduced by the outstanding loan balance.

A critical thing to remember when taking out a loan against your policy is that your policy could lapse if your loan balance equals or exceeds your policy’s cash value. At that point, your insurer will likely surrender your policy and use the funds to pay off the loan. If this occurs, you may face taxes and won’t have any proceeds from your policy.

Many life insurance policies have a surrender period during which you’ll pay fees if you take money out of the policy early. These periods vary by policy, so double-check before making a withdrawal.

Life Insurance With Living Benefits

Life insurance policies without a cash value can still provide liquidity through riders for living benefits or accelerated death benefit (ADB) riders, which pay out part of the death benefit before the insured person passes if certain conditions are met.

Generally speaking, ADBs allow you to get part of your death benefit early if specific events occur as a result of your health failing. The most common types of ADBs are for: 

  • Chronic illness: To qualify, you typically need to lose the ability to perform at least two activities of daily living (ADLs), such as bathing and feeding yourself.
  • Critical illness: If you experience a heart attack, stroke, cancer, or other events the insurer considers critical, you could qualify for this benefit.
  • Terminal illness: If you have a life expectancy of six months to two years, you could qualify for this benefit (the length of time varies between insurers). 
  • Long-term care: This is similar to the chronic illness rider in that to qualify, you need to lose the ability to perform two ADLs. However, it typically includes a waiting period and provides a monthly amount instead of a lump sum.

Because the funds for this rider come directly from the death benefit, beneficiaries receive a lower death benefit when the insured person dies.

How Beneficiaries Benefit From Liquidity

Life insurance policies provide a payout to beneficiaries when the insured passes away. This feature has several advantages, including delivering financial support to loved ones after you pass away. That’s especially comforting if you wouldn’t have been able to do so otherwise. Here are more ways your beneficiaries benefit from life insurance liquidity:

During Probate

In general life insurance policies are non-probate assets, so your beneficiaries quickly get payouts they can use for things like mortgage payments and living expenses while your estate is settled in court. Probate is a lengthy and sometimes expensive legal process where a probate court verifies the will of the person who passes, and the executor distributes assets accordingly. Non-life-insurance assets from the estate can sometimes go through lengthy probates, delaying beneficiaries’ access, and creating financial hardship. 

High-Value Estates

Having liquidity through life insurance policies can help beneficiaries avoid liquidating assets or family heirlooms to cover expenses of high-value estates, including: 

  • Legal expenses
  • Accountant fees
  • Other administration costs
  • Estate taxes
  • Inheritance taxes

For those with estates that might exceed the federal estate tax exemption of $12.06 million (as of 2022), it’s also worth considering strategies to reduce taxes, such as placing the life insurance policy in an irrevocable trust. Generally, doing so would exclude it from the value of your estate and limit its exposure to estate taxes. Such strategies may also be warranted if your state assesses estate and/or inheritance taxes as well.

Frequently Asked Questions (FAQs)

How do I tell how liquid my life insurance policy is?

A good way to find out how liquid your life insurance policy is would be to speak with your insurer. Ask them what options you have for withdrawing or borrowing against your death benefit.

What’s the fastest way to draw on the liquidity of a life insurance policy?

The fastest way to access the funds in a life insurance policy is to take a withdrawal or loan from its cash value. Be aware that you may pay surrender charges if you try to access them too early, and allowing a loan balance to equal or exceed your policy’s cash value could result in your insurer surrendering the policy and using the cash value to pay off the loan.

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