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Living off your life insurance

Life insurance » Living off your life insurance

Life insurance. It's usually a document we sign, file and forget -- except when the premiums come due. But it may also be an asset that can be tapped to ease a rough financial patch.

If you have permanent life insurance, part of your premium is paying the insurance company for the death benefit, and the remainder is invested to build cash value for you.

The three basic types of permanent life insurance -- universal life, whole life and variable life -- build up cash value in slightly different ways, and there are also differences in how you can access the cash.

Here are five options to consider if you want your life insurance to kick in during your life, not after your death.

Cash in your policy

While this may be the easiest step, consider why you got life insurance in the first place, says Kirk Okumura, adjunct professor of financial planning at The American College in Bryn Mawr, Pa. If you're the main breadwinner with young children to support or you do not want to burden your survivors with your final expenses related to dying, this may not be the best option.

Instead of the full death benefit -- the amount your family would collect on your demise -- you'll receive the current cash value of the policy minus any outstanding loans, unpaid loan interest and applicable surrender charges. But if you think you might need coverage in the future for any reason, keep in mind that it will be more expensive due to your increasing age and/or changing health. In fact, you could develop a condition or disease that makes obtaining life insurance very difficult, if not impossible, says Okumura.

Take out a loan against your policy

This may be the best route for a short-term loan, but don't expect to take out a life insurance policy and a loan the same day. The cash value -- the collateral for the loan -- starts slowly and then snowballs. The policy remains in effect, the funds are not taxable and there is no set repayment schedule.

But -- and this is a big but -- the loan is accruing interest. "I've heard of people who took out a relatively small loan against their life insurance policy, only to find with horror that it had turned into a huge loan thanks to the 'magic' of compound interest," says Steven J. Weisman, senior law lecturer at Bentley University in Waltham, Mass., and author of "A Guide to Elder Planning." Any amount of the loan or interest not repaid at the time of the policy holder's death will be subtracted from the death benefit.

Withdraw funds from the cash value

Again, this is something that won't be possible until you've built up a cash value. And again, the policy stays in force, but with a death benefit reduced by the amount of withdrawal. Any withdrawal that exceeds the amount of premiums paid will be subject to income tax, however. That means if the cash value is $20,000, and you've paid $10,000 in premiums but withdraw $15,000, then $5,000 will be taxed as income, not capital gains.

Exchange your policy

If you can't afford the premiums you're paying but still want coverage, you can do a 1035 exchange. (The number refers to the section of the tax code governing this transaction.) The same insured parties must be listed on the new policy, and you'll still have to go through a medical exam. And because you're older and there may have been health issues, your premiums may be higher, says Weisman.

Life settlements

In a life settlement you sell your policy to a third party, who pays the premiums until your death, at which time they get the death benefit, not your heirs. While a life settlement may bring in the most cash -- more than simply cashing in but less than the death benefit -- it is controversial financial transaction. And there likely will be tax implications, says Okumura. "In general, any monies received from or for a life insurance policy above what you've paid in premiums will be treated as ordinary income for federal income tax purposes," he says.

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