Life Insurance Payouts: Who Gets Them And How?

Life insurance is a contract between a policyholder and an insurance company that pays out a death benefit when the insured person dies. The death benefit is typically paid out as a lump sum, though some policies may offer other options like instalment payments or an annuity. The payout process begins when the beneficiary notifies the insurer. The insurer will then review the claim, and as long as everything is in order, the payout will be processed, helping provide financial security for the beneficiary.

Lump-sum vs. instalment payments

When it comes to life insurance payouts, there are several options for how the money can be paid out. The two most common are lump-sum payments and instalment payments. Here is a detailed comparison of the two:

Lump-Sum Payments

Lump-sum payments are the most common form of life insurance payout. This is when the beneficiary receives the entire payout all at once. This option is recommended by many experts because it is the simplest and gives the beneficiary full control over the money. Lump-sum payments are usually tax-free, and there is no limit to how much the beneficiary can receive. However, receiving a large amount of money at once can be overwhelming, and the beneficiary is responsible for making it last. If the payout is large, the beneficiary may need to spread it across multiple accounts, as the Federal Deposit Insurance Corporation (FDIC) only insures deposits up to $250,000 per depositor, per bank.

Instalment Payments

Instalment payments, also known as an annuity, are when the life insurance company pays the beneficiary a certain amount of money on a regular schedule (usually monthly, quarterly, or yearly) over a fixed period or for the rest of their life. This option can provide a steady income stream and make financial planning easier. However, any interest earned on these payments may be subject to taxation. Instalment payments may also result in the beneficiary receiving less money overall, especially if they pass away before the end of the fixed period.

Tax implications of payouts

Life insurance payouts are generally not taxable, but there are certain scenarios where taxes may apply. Here are the key points to consider:

• Income Tax on Interest: If the beneficiary chooses to receive the death benefit in installments, the interest generated on the payout is typically subject to income tax. This is because the insurance company holds the principal amount and pays out the benefit over a fixed period or the beneficiary's lifetime.
• Estate Taxes: If the death benefit is paid to the policyholder's estate instead of a named beneficiary, it may become part of the taxable estate. This could result in estate taxes if the total value exceeds certain thresholds. In the US, the federal estate tax exemption limit for 2024 is $13.61 million for an individual.
• Gift Tax: If the insured, policy owner, and beneficiary are three different people, the death benefit may be subject to gift tax. This occurs when the policyholder names an estate as the beneficiary, increasing the estate's value and potentially subjecting heirs to high estate taxes.
• Tax on Cash Value: Whole life insurance and other permanent life insurance policies build up a cash value over time, which can be withdrawn or borrowed against. Withdrawing more than the policy basis, which is the sum of premiums paid minus dividends received, may result in income tax on the excess amount.
• Tax on Surrendered Policies: Surrendering a permanent life insurance policy means cancelling the coverage and receiving the policy's cash value. The portion of the cash value that exceeds the policy basis is typically taxable as it reflects the investment gains.
• Tax on Sale of Policy: Selling a life insurance policy to a third party may incur income tax on the cash value that exceeds the policy basis, as well as capital gains tax on any profits from the sale.
• Tax on Cash Value Loans: Borrowing against the cash value of a life insurance policy is generally tax-free as long as the policy is active. However, if the loan is not repaid and the policy is cancelled, the amount exceeding the policy basis may be subject to income tax.

It is important to note that regulations and tax laws may vary by location, and it is always advisable to consult with a financial advisor or tax professional for personalized guidance based on individual circumstances.

Choosing a beneficiary

• Understand the role of a beneficiary: A beneficiary is the person or entity that you legally designate to receive the benefits from your life insurance policy in the event of your death. This is usually the reason people buy life insurance in the first place – to provide financial support to their loved ones after they're gone.
• Know the different types of beneficiaries: There are primary and contingent beneficiaries. Primary beneficiaries are the first in line to receive the death benefit, while contingent beneficiaries will receive the benefit if the primary beneficiary dies before the policyholder. You can also have multiple beneficiaries and allocate a percentage of the payout each will receive. Just ensure that the percentages add up to 100% in total.
• Consider your dependents and loved ones: Think about who relies on you financially and would need help paying ongoing bills or covering costs incurred by your death, such as funeral expenses. This could be your spouse, children, or other family members.
• Be specific: When designating a beneficiary, be as specific as possible. Instead of just writing "spouse" or "child", include identifying factors such as their full name, Social Security number, relationship to you, date of birth, and address. This will help the insurance company locate your beneficiaries quickly.
• Keep your beneficiary designations up to date: Remember to update your beneficiaries after major life changes such as marriage, divorce, or the birth of children. This will ensure that the right people are protected and that your wishes are carried out.
• Consider seeking legal advice: If you're unsure about who to choose as your beneficiary or how to designate them properly, consider consulting a financial professional or attorney. They can help you navigate any state laws or policy rules that may impact your decision.

Riders and their impact on payouts

Riders are optional add-ons to a life insurance policy that provide additional coverage or benefits that wouldn't be received otherwise. They can be added to both term and permanent life insurance policies, though the specific riders available depend on the insurer and the policy chosen. Riders are typically added when the policy is purchased, and they can increase the cost of premiums. However, some riders are included at no extra charge.

• Accelerated Death Benefit Rider: This rider allows the policyholder to access part or all of the death benefit while still alive if they have a terminal or chronic illness. The money can be used to pay for medical care, and any payouts will be subtracted from the total death benefit.
• Accidental Death Rider: This rider increases the payout to beneficiaries if the policyholder dies due to a covered accident. It may double the payout, but the death must occur within a set time after the accident.
• Child Term Rider: This rider provides a small death benefit if a covered child of the policyholder dies. It typically covers biological, step, and legally adopted children and can be converted into a permanent policy when the child reaches maturity.
• Long-Term Care Rider: This rider allows the policyholder to access the death benefit to pay for long-term care services if they have a chronic illness and are unable to perform daily living tasks. The death benefit is reduced accordingly.
• Return-of-Premium Rider: This rider refunds some or all of the premium payments if the policyholder outlives the term of the policy. It can significantly increase premium costs.
• Waiver of Premium Rider: This rider waives life insurance premiums if the policyholder becomes totally disabled and unable to work. The policyholder must provide proof of disability, and there may be a waiting period before the rider takes effect.

Other riders that can impact payouts include chronic illness riders, critical illness riders, and disability income riders, which provide funds to the policyholder if they are diagnosed with a covered illness or condition.

Claiming the insurance money

• Collect Important Documents: The first step is to gather all the necessary documents, which typically include the certified death certificate, the policy document, and the claim form. The death certificate serves as proof of death and can be obtained from the funeral home or medical professional who confirmed the death. The policy document provides details about the insurance policy, such as the policy number, death benefit amount, and beneficiaries. If you are having trouble locating the policy, you can contact the insurance company or the deceased's financial representatives. The claim form, also known as a "request for benefits", requires information about the policyholder, the cause of death, and your relationship to the policyholder.
• Contact the Insurance Company: Get in touch with the insurance company that issued the policy to notify them of the death and initiate the claim process. You can find their contact information on the policy document. If the policy was serviced through a broker, you can also reach out to them for assistance.
• Wait for the Claim to be Processed: Once you have filed the claim, the insurance company will perform some basic checks. They will verify that the policy is active and confirm your identity as the beneficiary. This process may take a few days to a few months, depending on the complexity of the claim and the state's regulations.
• Receive the Death Benefit: Upon approval of the claim, you will receive the death benefit from the insurance company. There are typically two common options for receiving the payout: a lump sum or an annuity. A lump sum payment provides the entire death benefit at once, and you won't have to pay taxes on it. An annuity, on the other hand, invests the death benefit into an account and pays it back in annual installments over a set number of years. The investment gains from an annuity option may be subject to taxes.

It is important to note that there is no time limit for filing a life insurance claim. However, it is recommended to initiate the process as soon as possible to access the financial support intended by the deceased for their loved ones.

Frequently asked questions