Accelerated death benefit riders: how they work and how they're taxed

An accelerated death benefit (ADB) rider lets the policy owner receive part of the death benefit while the insured is still alive, if the insured is diagnosed with a terminal illness. Many insurers include it automatically at no separate premium, but using it shrinks what your beneficiaries receive and the early payment is usually discounted. Federal law generally treats the payment as tax-free for a terminally ill person.

What the rider does

An accelerated death benefit rider moves some of the policy's face amount forward in time. If the insured is certified as terminally ill, the owner can request a lump sum, and the death benefit paid later is reduced by the amount advanced (plus any interest or charges the insurer applies). The advance can be used for anything: medical bills, home care, debts, travel, time with family. The NAIC's model regulation says there may be no restrictions on how the proceeds are used.

Most terminal-illness riders look like this:

• Trigger: a physician's certification that the insured is expected to die within a stated period. Twenty-four months is the NAIC model's example, but contracts vary, and some use 12 months. Check the number in your contract.
• Amount: the owner can often accelerate a percentage of the death benefit up to a dollar cap. Both the percentage and the cap are set by the insurer.
• Payment: a lump sum. The NAIC model regulation requires a lump-sum option and bars paying it only as a life annuity.
• Cost: often no premium, because the insurer prices the early payment in by discounting the benefit or charging interest.

Some riders also trigger on other conditions, such as a condition requiring extraordinary medical intervention or permanent confinement to a nursing facility. Those are different from the chronic-illness and long-term care designs covered in chronic illness riders vs long-term care riders.

How insurers reduce the payment

Insurers fund the early payment in one of a few ways. The NAIC Accelerated Benefits Model Regulation (#620) describes the approaches states have used as models:

1. A discount. The insurer pays the present value of the face amount accelerated, calculated with an interest rate disclosed in the contract.
2. A lien. The advance is treated as a loan against the death benefit and accrues interest until the insured dies.
3. A premium or cost-of-insurance charge for the rider, or an administrative fee.

For cash value, the model regulation generally limits the reduction to a pro rata share based on the percentage accelerated, or lets the insurer treat the advance as a lien and restrict access to the remaining cash value. The insurer must tell you in writing, before it pays, how the payment affects cash value, death benefit, premiums, loans and liens. State law adopts or modifies the model, so the details differ by state.

Tax treatment: IRC section 101(g)

Under 26 U.S.C. §101(g), an amount received under a life insurance contract on the life of an insured who is terminally ill is treated as paid by reason of the insured's death, which means it is generally excluded from gross income. The statute defines a terminally ill individual as one certified by a physician as having an illness or condition that can reasonably be expected to result in death in 24 months or less. The 24-month standard is the federal tax definition, which can differ from the window in your insurer's rider.

Two limits worth knowing:

• The statute treats chronically ill individuals separately. A payment to a chronically ill insured is tax-free only to the extent it covers qualified long-term care services, within the rules of section 7702B. See long-term care riders on life insurance.
• The exclusion does not cover a payment to someone other than the insured who has an insurable interest because of a business tie, such as being a director, officer, employee or creditor of the insured's business.

The NAIC model also requires insurers to disclose that accelerated payments may be taxable and that the owner should consult a tax advisor, so the rider paperwork will tell you to do so. A tax professional can confirm how the rules apply to your situation. For the broader picture of what is and is not taxed, see is life insurance taxable?.

Other effects to check before you accelerate

• Public benefits. The NAIC model requires the insurer to disclose that accelerated payments may reduce eligibility for Medicaid or other need-based benefits. Cash in the bank can count as a resource. See medicaid eligibility and life insurance cash value.
• Beneficiaries. An assignee or irrevocable beneficiary must sign off before payment under the model regulation. A divorce decree or loan assignment may also require consent.
• Remaining coverage. If you accelerate most of the benefit, premiums may continue on a much smaller death benefit. Ask whether the rider waives premiums on the accelerated amount and what happens to the rest.
• Waiting period. The model regulation allows the benefit to apply to illness no more than 30 days after the rider's effective date, and to accidents immediately.

ADB rider vs a viatical settlement

A rider is a feature of your own policy. A viatical settlement sells the policy to a third-party company for a lump sum. Settlement providers are regulated differently, and the sale ends your ownership. Use the rider first if your policy has one; a settlement may be considered if it does not, or if the policy has no accelerated option.

Steps to take if the insured is terminally ill

1. Read the rider's definition of terminal illness and the maximum benefit.
2. Ask the insurer for the written statement of how the payment affects death benefit, cash value, premiums and loans.
3. Ask a physician to complete the certification the insurer requires.
4. Get the beneficiaries' and any assignee's consents in order.
5. Check with a tax professional and, if the person receives need-based benefits, a benefits counselor or elder-law attorney.
6. Decide how much to accelerate; you can often take less than the maximum.

Key takeaways

• An ADB rider advances part of the death benefit to a terminally ill insured; the later death benefit is reduced by what is advanced plus any interest or charges.
• Many insurers include terminal-illness acceleration at no separate premium, but the payment is usually discounted, so read how the contract calculates it.
• Federal law (IRC §101(g)) generally excludes accelerated payments for a terminally ill person, defined as expected to die within 24 months, from income.
• Payments can affect Medicaid and other need-based benefits, cash value, loans and beneficiaries, so request the insurer's written disclosure first.