Life Insurance: Pre-Death Benefits And Payouts Explained

Life insurance is intended to provide financial security for your loved ones after you pass away. When you buy life insurance, you agree to pay premiums for your coverage, and in exchange, the insurance company pays out money to your beneficiaries after your death. The amount and nature of the payout depend on the type of policy you have and the options you choose. The two main types of life insurance are term and permanent, with the former providing coverage for a fixed period and the latter remaining in effect for the policyholder's lifetime as long as premiums are paid. Permanent policies may also include a cash value component that can be accessed by the policyholder during their lifetime. Upon the policyholder's death, beneficiaries must file a claim and provide the necessary documentation, such as a death certificate, to initiate the payout process. The insurance company will then review and approve the claim before issuing the payout according to the chosen option, which could be a lump sum, annuity, or retained asset account. Understanding the specifics of your policy and the available options is crucial to ensure that your beneficiaries can access the intended financial support when they need it.

Term life insurance payouts

Term life insurance is a policy that is valid for a specific term or period of time, such as 10, 20, or 30 years. If the insured person dies during the policy's term, the beneficiaries will receive the death benefit payout. However, if the insured person outlives the policy term, the coverage and the payout expire, and there is no money paid back.

Term life insurance policies offer straightforward payouts without any additional complexities. The process of receiving the payout is not complicated, but the beneficiary will need to make some financial decisions and handle some paperwork. Here is an overview of the process:

• As soon as possible after the insured person's death, the beneficiary should contact the insurance company to understand their procedure for filing a claim.
• The beneficiary will likely need to submit a certified copy of the death certificate and complete additional paperwork, such as a claim form.
• Although there is usually no deadline for filing a claim, it is recommended to do so as soon as possible.
• Once the claim is properly filed and all necessary documents are provided, the beneficiary will typically receive the death benefit payout within a month.

It is important to note that there may be rare circumstances that could cause delays in the payout process, such as if the policy was purchased recently, if there is suspected foul play, if fraud is detected, or if the insured person was killed during illegal activity.

The default payout option for most term life insurance policies is a lump-sum payment. However, beneficiaries have other options, including installments, retained asset accounts, and annuities, each with different tax implications. It is recommended to work with an insurance agent to determine the best payout option for your specific situation.

Permanent life insurance payouts

Permanent life insurance policies, such as whole life insurance, offer a more complex payout process than term life insurance policies due to their cash value component. This cash value component is a pool of money that can grow, typically through investments, and can be borrowed against or withdrawn by the policyholder during their lifetime.

Cash Value Component

Permanent life insurance policies build a cash value over time, which is accessible to the policyholder. This cash value grows tax-deferred and can be a useful source of funds for the policyholder. However, it's important to note that borrowing against or withdrawing from the cash value will impact the death benefit.

Borrowed Cash Value

If the policyholder borrows from the cash value and doesn't repay it, the amount borrowed, plus any interest, will be deducted from the death benefit. This means that the beneficiaries will receive a reduced payout.

Withdrawn Cash Value

Withdrawing money from the policy's cash value permanently reduces the death benefit. Unlike loans, withdrawals cannot be repaid, and the original death benefit cannot be restored.

Dividends

Some mutual life insurance companies pay dividends to policyholders, which can be used to buy paid-up additions (PUAs). PUAs are small amounts of additional life insurance that have their own death benefit and cash value, increasing the overall value of the policy over time.

Graded Death Benefit Period

For guaranteed issue policies, the full death benefit may only be available if the policyholder dies after a specific period, known as the graded death benefit period. If the insured dies within this period, beneficiaries typically receive a return of premiums paid, plus interest or a smaller percentage of the death benefit.

Riders

Riders are optional add-ons that provide additional benefits and can impact the final payout. For example, an accidental death benefit rider could significantly increase the payout if the policyholder dies due to an accident. Other riders, such as the accelerated death benefit rider, chronic and critical illness riders, and the long-term care (LTC) rider, offer living benefits to the policyholder but may reduce the final payout.

Payout Options

Beneficiaries of permanent life insurance policies have multiple payout options, including lump-sum payments, installments, retained asset accounts (RAA), interest-only payouts, lifetime annuities, and fixed-period annuities. Each option has different tax implications, and beneficiaries should consider their financial needs and preferences when choosing a payout method.

Lump-sum payment

A lump-sum payment is the most common type of life insurance payout. It gives beneficiaries full control over the money and allows them to use it as they see fit. This option is especially useful when there are multiple beneficiaries, as it allows them to receive a single payment that includes the entire death benefit.

The lump-sum option provides immediate access to the full amount, which can be crucial for covering significant expenses or debts, such as funeral costs, mortgage payments, everyday bills, or college tuition. It also gives beneficiaries the flexibility to invest the payout in retirement accounts to secure a comfortable future or create an emergency fund for unexpected expenses.

However, receiving a large amount of money at once can be overwhelming for some beneficiaries, who may feel the pressure of making the money last. Additionally, if the payout is particularly large, it may need to be spread across several bank accounts to stay within Federal Deposit Insurance Corporation (FDIC) limits.

Installments

One option for receiving a life insurance payout is to have the insurer pay out the death benefit in installments over a fixed period or for the beneficiary's lifetime. This option can provide a steady income stream, making financial planning easier. The installments can be set to a specific amount paid monthly, quarterly, or annually until the proceeds are depleted.

The beneficiary of a whole life insurance policy may have the option to receive the death benefit in installments. This is also known as a specific income payout. The insurance company will place the payout into an interest-bearing account, and the beneficiary will receive payments of their chosen amount on a monthly or annual basis. The interest on the account is taxable.

The lifetime annuity option provides guaranteed payments to the beneficiary for the rest of their life. The amount is determined by the beneficiary's age. If the beneficiary dies before the death benefit is exhausted, the remaining amount typically reverts to the insurer.

The fixed-period annuity option is where the death benefit is paid out over a specified period, 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.

Any interest earned on installment payments may be taxable.

Retained asset account

A Retained Asset Account (RAA) is a type of account that operates like a checking account, with the initial balance being a life insurance or annuity death benefit. This option was established in 1984 as an alternative to receiving a lump-sum payment, which was the default choice before that.

With an RAA, the beneficiary of a life insurance policy can keep the death benefit in an account that earns interest, while also having easy access to the funds via free checks. The principal and a minimum rate of interest are guaranteed by the insurer, with additional interest credited at a rate declared by the insurer, comparable to that of similar accounts offered by banks and money-market mutual funds.

While the money stays with the life insurer, it is protected and the beneficiary has full access to it at all times. The funds are likely safer with the insurer than in a bank, even considering FDIC insurance. Historically, more banks have failed than insurers, and there is a state guaranty fund system that insures at least as much as the FDIC does, and often more.

The beneficiary can withdraw the money at any time by writing a check for the full amount or leave it in the account indefinitely. The death benefit is income-tax exempt, but there may be tax considerations that affect when it is most advantageous to withdraw the money.

While insurers typically earn a higher rate on their investments than they credit to these accounts, they still pay a competitive interest rate. They also bear all the investment risk and guarantee a positive rate of return, even if they lose money on their investments.

Frequently asked questions