Understanding Life Insurance Proceeds Distribution

Life insurance is a contract between a policyholder and an insurance company that pays out a death benefit when the insured person passes away. The proceeds from a life insurance policy are usually distributed to the designated beneficiary or beneficiaries, who may be individuals or organisations. There are several ways a beneficiary may receive a life insurance payout, including lump-sum payments, installment payments, annuities, and retained asset accounts. The choice of payout option will depend on the beneficiary's financial goals and risk tolerance. While life insurance proceeds are generally tax-free, any interest earned on the payout may be taxable.

Naming beneficiaries

A life insurance beneficiary can be a spouse, child, other family member, business partner, charitable organisation, or the legal guardian of a minor. You can choose to name a single beneficiary or a primary beneficiary and one or more contingent beneficiaries. A contingent beneficiary would receive the death benefit if the primary beneficiary passes away.

When naming minor children as beneficiaries, it is important to note that they cannot receive any benefits until they reach the age of majority as defined by state law. Therefore, a legal guardian would need to be appointed to manage the funds on their behalf until they come of age.

To ensure a smooth claims process, it is essential to keep your beneficiary information up to date. Life circumstances can change over time, and you may need to update your beneficiary designations accordingly. For example, couples should name contingent beneficiaries for each other to protect their survivors in the event of simultaneous death.

By taking the time to carefully consider and designate your beneficiaries, you can have peace of mind knowing that your life insurance policy will provide financial support to your loved ones or chosen organisations after your passing.

Lump-sum payments

While it is not necessary for your beneficiary to take a lump sum, it is a preferred option for many. However, if the beneficiary chooses to do so, they may face higher taxes on the interest if the death benefit is fairly high. Therefore, it is recommended to consult a financial professional to determine the best payout option.

Additionally, lump-sum payments offer flexibility, as the beneficiary can choose to receive a combination of options. For instance, they could receive the interest option until retirement and then receive the remainder of the benefit as an annuity.

Installment payments

When a loved one passes away, their beneficiaries are faced with the challenging task of figuring out how to use the life insurance proceeds. One option for distributing life insurance proceeds is through installment payments. This option provides beneficiaries with regular income over a period of time, typically ranging from five to 40 years. For example, a beneficiary may receive 10% of the total death benefit each year for ten years. During this time, the remaining death benefit continues to earn interest for the beneficiary.

Compared to a lump-sum payment, installment payments may result in higher taxes on the interest income if the death benefit is substantial. On the other hand, a lump-sum payment may lead to impulsive spending decisions, such as buying a sports car or going on a spending spree. Delaying immediate financial decisions and taking the time to research options can help beneficiaries make informed choices that align with their long-term financial goals.

In conclusion, installment payments can provide beneficiaries with a steady income stream and peace of mind, knowing that the proceeds will last for a certain number of years. However, it's important to carefully weigh the benefits against the potential tax implications and consider seeking guidance from a financial professional.

Annuities

When it comes to life insurance proceeds, annuities can be used to purchase a stream of income for beneficiaries. This can be particularly useful for young families who have lost a breadwinner or retirees who have lost a source of income. However, it is important to note that annuity death benefits are typically smaller relative to life insurance payouts, and beneficiaries may owe income tax on the earnings.

Retained asset accounts

A Retained Asset Account (RAA) is a temporary repository of funds that gives the beneficiary time to consider their financial options. The payment of the total proceeds will be accomplished by delivery of a "checkbook". While the documents received might look like a checkbook, they are actually drafts, which are similar to checks but different in some ways. RAAs are generally provided as an option to the beneficiary, however, for some group policies, the employer might have agreed that an RAA is the only way life insurance claims are settled.

The new settlement option, established in 1984, creates a checking account whose initial balance is the death benefit. The principal and a minimum rate of interest are both guaranteed by the insurer. Additional interest is credited to the account at a rate declared by the insurer, which is comparable to that paid in similar accounts offered by banks and money-market mutual funds. Beneficiaries get free checks and periodic reports on the status of their account.

The money in an RAA can be withdrawn immediately by writing a check for the full amount, or it can be left in the account for as long as the beneficiary wants. The death benefit is income-tax exempt, but tax considerations might affect when the beneficiary might most advantageously withdraw the money. While the money stays with the life insurer, it is protected, and the beneficiary has full access to the funds at all times. The money is as safe, perhaps even safer, with the insurer than with a bank, even taking into account FDIC insurance.

The only money that can be added to an RAA is money that comes from another life insurance death benefit from the same insurance company. This is not a deposit account like those provided by a bank or money market mutual fund.

Frequently asked questions