Whole Life Insurance: Lump Sum Payments Explained

Life insurance is an important tool for long-term financial planning and protecting your loved ones. It is a contract between a policyholder and an insurance company that pays out a death benefit when the insured person passes away. There are several types of life insurance, including term and permanent plans, each with its own unique features and benefits. One option that stands out for its simplicity and efficiency is single premium life insurance, which usually refers to a permanent life insurance policy funded by a one-time lump-sum payment. This type of policy guarantees a death benefit and offers faster cash value accumulation. However, it also comes with a high upfront cost and potential tax implications, making it a strategic choice for individuals with large estates or inherited money. Understanding the pros and cons of single premium life insurance is essential before committing to such a substantial upfront investment.

Single-premium life insurance

There are two popular types of single-premium policies: single-premium whole life and single-premium variable life. Single-premium whole life offers a risk-free fixed interest rate, while single-premium variable life invests the cash value in actively managed portfolios, coming with the potential risks and rewards of active investing.

However, single-premium life insurance is not without its drawbacks. As well as the high upfront cost, single-premium life insurance policies are typically classified as Modified Endowment Contracts (MECs), which can have specific tax implications, particularly regarding the treatment of loans and withdrawals from the policy.

Lump-sum payments vs. annuities

Life insurance is a contract between a policyholder and an insurance company that pays out a death benefit when the insured person passes away. There are several kinds of life insurance, including term and permanent plans.

When it comes to receiving the death benefit, there are a few options available to beneficiaries. The most common payout option is a lump-sum payment, where beneficiaries receive the entire death benefit in one single, usually tax-free, payment. This method provides immediate access to the full amount, which can be crucial for covering significant expenses or debts.

Another option is to receive the death benefit in installments over a fixed period or for the beneficiary's lifetime, known as an annuity. This option can provide a steady income stream, making financial planning easier. However, any interest earned on these payments may be taxable.

So, what are the key differences between lump-sum payments and annuities, and which option is better?

Lump-sum payments offer more flexibility as beneficiaries can use the money for any purpose, such as paying off debts or investing in other assets. However, this option also comes with more responsibility as the beneficiary is in charge of managing the money and ensuring it lasts. There is also the risk of poor investment decisions or outliving the lump sum.

On the other hand, annuities provide a reliable and steady income stream, offering a sense of security in retirement. Annuities are essentially an insurance policy against outliving your savings. However, they offer less flexibility as the beneficiary generally cannot access the lump sum after annuitizing the pension. There may also be fees, surrender charges, or limitations on withdrawals associated with annuities.

When deciding between a lump-sum payment and an annuity, it is important to consider various factors such as life expectancy, financial situation, risk tolerance, and tax implications. If you are confident in your financial management skills and want more control over your money, a lump-sum payment might be the best option. However, if you prefer a more hands-off approach and want a guaranteed income stream, an annuity may be more suitable.

In summary, both lump-sum payments and annuities have their own advantages and disadvantages. Lump-sum payments offer more flexibility and control, while annuities provide a reliable income stream and protect against the risk of outliving your savings. The best option for you will depend on your personal circumstances and financial goals.

Tax implications

Life insurance death benefits are typically tax-free, but there are exceptions. For example, if your loved ones choose to receive the life insurance payout in installments instead of a lump sum, any interest that builds up on those payments could be taxed. That extra money from interest is considered taxable income, even though the original death benefit is not.

Another exception occurs when a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary. If the estate's total value is large enough, it may trigger estate taxes, reducing what your loved ones ultimately receive.

Cash value life insurance, like whole or universal life, also has its own tax rules. Policyholders can generally borrow or withdraw money from the policy's cash value, and as long as they don't take out more than they've paid in, those withdrawals are usually tax-free. However, if there are unpaid loans against the policy, they will be deducted from the death benefit, meaning your beneficiaries get less.

If the policy is a modified endowment contract (MEC), taxes are different. For tax purposes, withdrawals are on a last-in, first-out (LIFO) basis. This means that all withdrawals are treated as taxable income until they cumulatively equal all interest earnings in the contract.

In most cases, life insurance proceeds are not considered taxable income, and the beneficiary does not have to report the payout on their taxes. However, any interest they receive is taxable and should be reported.

If the policy was transferred to you for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration you paid, additional premiums you paid, and certain other amounts. There are some exceptions to this rule. Generally, you report the taxable amount based on the type of income document you receive, such as a Form 1099-INT or Form 1099-R.

A lesser-known tax issue can arise in what's called a Goodman Triangle. This occurs when three different individuals are involved in a life insurance policy — one person is the policy owner, another is the insured, and a third is the beneficiary. In this scenario, the IRS could view the death benefit as a gift from the policy owner to the beneficiary, triggering a gift tax if the amount exceeds the annual exclusion limit, which is $18,000 in 2024. To avoid this complication, many financial advisors suggest that only two parties be involved in the policy.

If the death benefit is paid out in installments and the remaining portion earns interest, that interest would be taxable.

A life insurance payout might also be taxable if it's paid to the insured's estate instead of an individual or entity. In 2024, estates over $13.61 million owe estate tax.

If the owner of the policy is not the same as the insured, the payout to the beneficiary could be considered a taxable gift.

Pros and cons

Pros of Lump Sum Payments on Whole Life Insurance

• Lump sum payments are the most common payout option by far because they give people the most flexibility.
• You have full control over the money and can use it how you want.
• The death benefit is tax-free and can be significant compared to the premium paid.
• The death benefit can provide immediate cash resources to cover funeral expenses and can be easily divided among heirs.
• Lump sum payments are permanent, whereas a term policy only extends coverage for a set period.
• Lump sum payments allow you to have a hands-free approach to managing the policy.
• Lump sum payments offer living benefits, which can fund a variety of expenses such as long-term care.
• Lump sum payments allow you to borrow against the death benefit tax-free to make payments for long-term care.
• Lump sum payments offer faster cash value growth than other permanent and term life insurance because they are fully funded from the start of coverage.

Cons of Lump Sum Payments on Whole Life Insurance

• Receiving such a large amount of money at once can be overwhelming.
• If you’re putting the money in a checking or savings account, you might have to spread it across several accounts if you receive a large payout.
• The interest rate the insurer provides might not be as high as what you can get with a high-yield savings account or by investing the money.
• The interest earned on the account will be taxable.
• The younger you are, the smaller the payout amounts will be because they will have to be distributed over a longer period.
• There could be fees associated with this option and a surrender charge if you want to withdraw all of the cash.
• If you die before you collect the full life insurance benefit, the insurance company will keep what is left.

Choosing beneficiaries

• Who can be a life insurance beneficiary? Almost anyone can be a life insurance beneficiary, including people, organisations and trusts. Some common examples are a spouse, multiple people like your children, a charitable organisation, or a legal entity like your company.
• Primary vs. contingent beneficiary: Primary beneficiaries are first in line to receive the life insurance death benefit if you die. Contingent beneficiaries receive the death benefit if the primary beneficiary dies before you do.
• Multiple beneficiaries: If you name multiple beneficiaries, you can choose how much of the payout each party receives. For example, you could allocate 50% to your spouse, 30% to your child, and 20% to a charity.
• Irrevocable vs. revocable beneficiaries: You cannot change an irrevocable life insurance beneficiary without the beneficiary's approval. For this reason, irrevocable designations aren't common. In contrast, a revocable beneficiary can be changed, updated, added, or removed at any time.
• Age of beneficiary: Naming a minor is often not advised because insurers typically do not disburse policy proceeds directly to minors. Knowing this, you may want to set up other arrangements, such as appointing a trustworthy guardian or setting up a trust, to oversee the funds on behalf of the minor until they reach legal adulthood.
• Community property states: If you live in a community property state and used money earned during your marriage to pay your life insurance premiums, your spouse may automatically be entitled to a percentage of the death benefit. To keep this from happening, your spouse must give written consent to the named beneficiary before you die. States with community property laws include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
• Changing, adding, and removing beneficiaries: You can typically change, add, or remove revocable life insurance beneficiaries at any time. The methods to do so vary among insurers. Some companies may require a change of beneficiary form signed by a witness, while others allow you to update your beneficiary online.
• When to change your life insurance beneficiary: It's important to reassess your life insurance beneficiaries after major life changes to ensure the right people are protected. Some situations that might prompt you to review your previous selections are getting married or divorced, having children, your children no longer relying on you financially, or your beneficiary dying.

Frequently asked questions