Key Things
The payout process depends on whether you have a long-term or permanent life insurance policy. Term policies offer outright payouts, while permanent policies include a cash value component.
Clearly designate primary and contingent beneficiaries to ensure that death benefits go to the intended beneficiaries, whether they are individuals or charities.
A policy cash value loan can be repaid to restore the death benefit, while withdrawals permanently reduce the death benefit without accruing interest.
Beneficiaries have several payout options, including lump sums, installments, retained asset accounts and annuities, each with different tax implications.
As you get older and have more responsibilities, it is common to wonder what will happen after you die and how you will be able to provide for your family. Taking out life insurance is one way to ensure financial security after your death. Life insurance policies offer a payment known as a death benefit, but how much is paid and under what circumstances depends on the type of policy you have. Understanding your policy type and its life insurance payout is important to ensure your beneficiaries have access to the death benefit when it matters most.
Understanding Life Insurance Payouts
Before we get into the details of the death benefit and how the money is distributed, it’s important to understand how life insurance policies are designed to pay out. When taking out a life insurance policy, the policyholder must decide who will receive the benefit in the event of death. This person is called the recipient. The period during which the beneficiary is entitled to a death benefit will be determined by the type of life insurance. While a term life insurance policy remains active for a specified period of time for a set amount, a permanent life insurance policy is designed to be active for the entire life of the policyholder as long as the premiums are paid.
Recipients
One of the most important elements of the life insurance application process is determining the primary beneficiary or beneficiaries. It can be one person or more people, or it can be an entity such as a charity.
You can also designate an eventual recipient. This person or entity is the secondary beneficiary of your insurance policy payout. If your primary beneficiary dies before you do, the eventual beneficiary will receive your death benefit.
Term Life Insurance Payouts
If you have a life insurance policy, the cover lasts for a certain period of time – for example 10, 20 or 30 years – and includes a simple death benefit if you die during the life of the policy.
Permanent Life Insurance Payouts
Permanent life insurance, like whole life insurance, offers a payout process that involves additional complexities compared to term life insurance, primarily due to their cash value component. Here’s a breakdown to help you understand how life insurance pays out:
Cash Value Component: Permanent life insurance policies build cash value over time that the policyholder has access to during their lifetime. This cash value grows tax-deferred and can be borrowed or withdrawn.
Borrowed Cash Value: If the policyholder borrows from the cash value and does not repay it, the borrowed amount plus any interest will be deducted from the death benefit.
Cash Value Withdrawn: When you withdraw money from the cash value of your policy, it permanently reduces the death benefit. Unlike loans, withdrawals cannot be repaid to restore the death benefit.
Dividends: Some mutual life insurance companies pay dividends to policyholders. These dividends can be used in a variety of ways, such as by purchasing paid-up allowances (PUAs). PUAs are small amounts of supplemental life insurance that have their own death benefit and cash value, increasing the overall value of your policy. Therefore, using dividends to purchase PUAs can increase the mortality rate of your beneficiaries over time.
Gradual Death Period: For guaranteed issue policies, the full death benefit may only be available if the policyholder dies after a certain period known as the Gradual Death Period. If the insured dies within this period, the beneficiaries are usually refunded the premiums paid plus some interest or a smaller percentage of the death benefit.
Loans Vs. Loans Explained Selections
It can be easy to confuse loans and permanent life insurance withdrawals because both involve accessing cash value. However, they affect your policy and death benefit in different ways. Here is a clearer breakdown with examples:
Loans
When you borrow against the cash value of your policy, you’re essentially getting an advance against the death benefit and using the cash value as collateral. This loan can be repaid while you are alive, restoring the original death benefit. If not repaid, the loan amount plus any accrued interest will be deducted from the death benefit before your beneficiaries receive any payment.
Example: Imagine you have a $500,000 term life insurance policy and borrow $10,000 to cover medical expenses. If you pay off this $10,000 loan plus any interest, your death policy will remain at $500,000. However, if you default on the loan and have accrued $1,000 in interest, your beneficiaries will receive $489,000 ($500,000 – $10,000 – $1,000).
Selections
Some types of permanent policies allow withdrawals. When you withdraw money from the cash value, this is a permanent reduction in your death benefit. Withdrawals are interest-free and cannot be redeemed to restore the original death benefit.
Example: Let’s say you have a $500,000 policy and withdraw $10,000 to pay for home repairs. This selection permanently reduces your death benefit to $490,000. There is no option to repay $10,000 to increase the death benefit back to $500,000.
Overview of Banking
If you’re considering taking out a loan against your policy or making a withdrawal, it’s important to remember that the policy’s death benefit, also known as the face amount, is not your balance. You only have access to monetary values. For example, you might have $250,000 in whole life insurance with an accumulated value of $4,350. $4,350 is the amount you would have access to through a loan or withdrawal.
Plus, you usually can’t borrow the full $4,350. Your policy will determine what portion is available. For example, an insurance company may only allow you to borrow up to 92 percent to ensure there is enough margin to charge interest.
If you default on the loan, it will continue to accrue interest, and if the unpaid balance ever exceeds the total cash value, your policy will terminate.
Riders Can Affect Payouts
Riders are optional add-ons to a life insurance policy that provide additional benefits. They can also affect the final payout. Some riders may increase a death benefit or offer a living
Types of Life Insurance Payouts
Life insurance payouts can be received in a variety of ways, offering beneficiaries flexibility based on their financial needs and preferences. Here are the main types of payments available:
Lump sum payment: This is the most common payment option. Beneficiaries receive the entire death benefit in one single, usually tax-free, payment. This method provides immediate access to the entire amount, which can be crucial to cover significant expenses or debts.
Installments: Beneficiaries can choose to receive death benefits in installments over a fixed period of time or for life. This option can provide a steady stream of income and facilitate financial planning. Repayments can be set to a specific amount paid monthly, quarterly or annually until the income is exhausted. However, any interest earned on these payments may be taxable.
Retained Asset Account (RAA): This is an interest-bearing account where the insurer holds the death benefit and provides the beneficiary with a checkbook to draw funds as needed. This option offers flexibility and easy access to funds while earning interest. However, the interest earned may be subject to tax.
Interest Only Payment: With this option, the insurer retains the death benefit and pays only the interest earned on the amount to the beneficiary. The principal remains intact and can be transferred to other beneficiaries after the death of the original beneficiary. This option provides regular income but may come with taxable interest.
Life Annuity: A life annuity provides guaranteed payments to the beneficiary for the rest of his life. The amount is determined by the funeral and the age of the recipient. If the beneficiary dies before the death benefit is exhausted, the remaining amount is usually returned to the insurer.
Fixed-Term Annuity: With a fixed-term annuity, the death benefit is paid over a set period of time, such as 10 or 20 years. If the beneficiary dies before the end of this period, their designated beneficiaries can continue to receive the remaining payments. This method ensures regular income for a specified period of time.
Life Insurance Payout Process
The life insurance payout process is not complicated, but it does require the beneficiary to make certain financial decisions and complete some paperwork. Here’s what you need to do:
Make a Claim
Contact the insurance company as soon as possible after the death of the policyholder and find out their procedure for making a claim. You will probably need to submit a certified copy of the death certificate and fill out other paperwork such as an application form. Although there is no deadline for filing a claim, it is wise to file it as soon as possible. Your state will have laws that dictate how long an insurer has to review your claim after it’s filed—often 30 to 60 days.
Possible Problems
If you file your claim properly and provide all the necessary documents, you will usually receive your life insurance death payout within a month. However, in rare cases there may be a delay. The following situations may cause delays:
Date of policy purchase: Insurance policies are usually disputed by the company within the first two years they are in force, so if the policyholder purchased the policy recently, the insurer may have questions because life insurance claims on new policies can be a red flag of fraud. . If the death was by suicide, benefits could be denied if the contract contained a suicide clause.
Suspicion of foul play: If the policyholder has been murdered, there may be a delay as the insurance company works with the police to ensure that the claimant was not involved in a crime.
Fraud: If the policyholder has lied or misrepresented information on the application, the insurance company can usually do a thorough check to see if the policy is valid, even after the dispute period has ended. Some life insurance policies will have a non-dispute clause written into the policy, so it is important that you review the policy with a licensed professional if you have any questions.
Policyholder Killed During Illegal Activity: If a policyholder has been killed while committing a crime, the insurer may delay or even deny payment of benefits due to a policy review and potential ongoing criminal investigation.
Common Payment Methods
One of the main advantages of life insurance in the event of death is the flexibility it offers, as there are no restrictions on how the money can be spent. Common ways to use your paycheck include:
Paying off your mortgage: Eliminating a large debt like a mortgage can provide financial security and peace of mind.
Saving for college tuition: Setting aside funds for a child or grandchild’s education can ensure they have the resources they need for their future.
Paying off consumer debt: Reducing or eliminating credit card debt or other loans can ease your financial burden.
Saving for retirement: Investing your paycheck in retirement accounts can help ensure a comfortable future.
Create an emergency fund: Creating a reserve for unexpected expenses can provide a financial safety net.
Are Life Insurance Payouts Taxed?
In most cases, life insurance payouts to beneficiaries are exempt from income tax. However, there are certain scenarios where taxes may apply:
Interest income: If the death benefit accrues interest before payment, the interest portion is taxable as income.
Goodman’s Triangle: This situation occurs when the policyholder, the insured and the beneficiary are three different people. For example, if a mother (the policyholder) takes out a policy with her son (the insured) and names her husband as the beneficiary, the funeral benefits can be considered a gift from the policyholder to the beneficiary. This can trigger a gift tax because the IRS views it as the policyholder (the mother) making a financial gift to the recipient (the spouse).
Estate Tax: If death benefits are paid to the policyholder’s estate instead of a named beneficiary, the payment may become part of the policyholder’s taxable estate and potentially subject to estate tax.
Understanding these exemptions can help beneficiaries plan for any potential tax liabilities. A consultation with a financial advisor or tax professional can provide personalized advice based on individual circumstances.
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