Life Insurance Payouts: Who Benefits And How?

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 ways to get money from life insurance, depending on the type of policy you have. Term life insurance is typically more affordable but does not build cash value, whereas permanent life insurance policies are usually more expensive and provide coverage for your entire life, allowing you to build a cash value that can be used to supplement retirement income or cover large expenses. This cash value can be accessed through withdrawals, loans, or by surrendering the policy, but it's important to consider the potential impact on the death benefit and any tax implications.

Cancelling a life insurance policy

Term Life Insurance Policy

Cancelling a term life insurance policy is generally a straightforward process. One effective way to cancel is by stopping premium payments. If you have automatic payments set up, you may need to contact the insurance company to end these transfers. Alternatively, you can call or send a letter to your insurance provider to notify them of your decision to cancel. It is recommended to keep a written record of the cancellation and confirmation that your policy has been terminated.

Whole Life Insurance Policy

Cancelling a whole life insurance policy is more involved due to the additional elements, such as the cash value component. When surrendering a permanent life insurance policy, you may receive a payout from the cash value, but this may be reduced by surrender charges, especially if the policy is relatively new. Cancelling within the first 10 years of owning a whole life policy may result in high penalties and a loss of cash surrender value. It is important to review the policy's guidelines regarding surrender periods and fees before cancelling.

Universal Life Insurance Policy

Universal life insurance, another form of permanent life insurance, offers flexibility in changing the death benefit or lowering premiums. The cash value account's earnings can also help pay the premiums. However, universal life insurance policies may lapse prematurely due to inadequate funding, increased costs as the insured ages, or a low-interest crediting rate.

Considerations Before Cancelling

Before cancelling your life insurance policy, it is essential to consider alternatives and potential consequences. Cancelling your policy may result in a loss of coverage for your loved ones and forfeiting your current rates. If you decide to cancel due to affordability, explore options such as reducing the coverage amount, shopping for a new policy, or using the cash value to cover premiums. Additionally, review your policy's guidelines, contact your insurance provider, and seek advice from a financial advisor or insurance expert to understand the financial implications of cancelling.

Withdrawing from a life insurance policy

There are a few ways to withdraw money from a permanent life insurance policy:

Withdrawing Money

The policyholder can withdraw money from the cash value portion of their permanent life insurance policy. Withdrawing up to the amount paid in premiums can be done without paying taxes on the funds. Withdrawing more than this amount may result in taxation. Withdrawing money will reduce the death benefit paid out to beneficiaries.

Surrendering the Policy

The policyholder can surrender their policy, which means cancelling the coverage and receiving the surrender value of the policy. This value is generally less than the value in the cash account due to surrender fees. Surrendering a policy before retirement age is usually considered a last resort, as the policyholder will no longer have life insurance coverage. Surrender fees can be high, especially for newer policies, but they generally decrease over time.

Borrowing Against the Policy

The policyholder can borrow money through their permanent life insurance policy, using the policy as collateral. The money is borrowed from the insurer, not the policy itself, and interest rates are typically lower than those for personal loans or home equity loans. There is no loan application or credit check, and the credit rating does not impact the interest rate. The loan does not need to be repaid, but if it is not, the outstanding loan balance will be deducted from the death benefit paid out to beneficiaries.

Using Cash Value to Pay Premiums

The policyholder can use the money in the cash value of their permanent life insurance policy to pay part or all of their policy premiums. This is a popular option for older policyholders who want to continue their life insurance coverage while using retirement income for living expenses.

It is important to note that withdrawing money from a permanent life insurance policy will reduce the death benefit paid out to beneficiaries. There may also be taxes and fees associated with withdrawing money, depending on the specific terms of the policy.

Borrowing from a life insurance policy

Permanent life insurance policies are typically more expensive than term life insurance policies because they provide coverage for your entire life and can build cash value, which can be used for future expenses like supplementing retirement income.

How It Works

When borrowing from a life insurance policy, you are essentially borrowing from yourself, with the policy's cash value serving as collateral. This means that the cash value continues to grow, even when you borrow against it. There is no approval process, credit check, or income tax on the money you take out. However, interest will be added to the loan balance, and if left unpaid, it can cause the policy to lapse.

Repayment

While there is no strict repayment schedule for life insurance loans, it is important to pay back the loan in a timely manner, in addition to your regular premium payments. The longer the loan is left unpaid, the more interest will accrue. If the loan amount exceeds the policy's cash value, the policy could lapse, and you may owe taxes on the amount borrowed.

Impact on Death Benefit

It is important to note that taking out a loan against your life insurance policy will reduce the death benefit. If you pass away with an outstanding loan balance, the loan amount and any interest owed will be deducted from the death benefit, resulting in a lower payout for your beneficiaries.

Loan Amount

The amount you can borrow against your life insurance policy is usually limited to a certain percentage of its cash value, typically up to 90%. Each insurance company will have different rules, and it may take several years for the policy to build up enough cash value to borrow against.

Alternatives to Borrowing

Before borrowing from your life insurance policy, consider other options such as using a credit card with a cash advance option, taking out a personal loan, or a home equity loan. These alternatives may provide a more favourable impact on your overall financial situation, especially if you are able to secure a low-interest rate.

In conclusion, borrowing from a life insurance policy can be a convenient way to access cash, but it is important to understand the potential risks and impacts on your death benefit and overall financial plan. Be sure to weigh the pros and cons before making any decisions.

Using cash value to pay premiums

Permanent life insurance policies, such as whole life and universal life insurance, allow you to use the money in your cash value to pay part or all of your policy premiums. This is a popular option for older policyholders who want to use retirement income for living expenses but still want to maintain life insurance coverage.

When you buy a permanent life insurance policy, a portion of the premiums you pay is set aside by the life insurance company in what is known as the cash value component of your policy. Over time, this cash value grows and can eventually be accessed for various purposes. However, it usually takes a few years for the cash value in a policy to grow to a usable sum.

When you make a premium payment on a cash-value life insurance policy, one portion of the payment is allotted to the policy's death benefit, another covers the insurance company's operating costs and profits, and the rest contributes to the policy's cash value.

The cash value in a permanent life insurance policy can be used in several ways, including paying premiums, taking out loans, creating investment portfolios, and supplementing retirement income.

It is important to note that the funds allotted to cash decrease while those paid to cover insurance increase as the policyholder ages. Therefore, it is crucial to monitor the cash value to ensure it doesn't drop too far, or the coverage may be lost.

Choosing a life insurance beneficiary

Who can be a life insurance beneficiary?

Almost anyone can be a life insurance beneficiary, including people, organizations and trusts. Here are some common examples of life insurance beneficiaries:

• A person, like your spouse.
• Multiple people, like your children.
• A charitable organization.
• A legal entity, like your company.

Some insurers place limits on how many beneficiaries you can name. If your policy has a limit, be selective when compiling your list.

The beneficiaries you choose when you purchase a policy must have an “insurable interest” in your life. This means they have more to lose than gain by your death, whether that's financial or otherwise.

Primary vs. contingent beneficiary

Primary life insurance beneficiaries are the first in line to receive the life insurance death benefit if you die. Contingent life insurance beneficiaries, sometimes called secondary 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 might allocate 50% to your spouse, 30% to your child, and 20% to a charity. No matter how you divide a life insurance payout among beneficiaries, the percentages must add up to 100%. If you don’t list the percentages, the insurer may grant equal shares to each beneficiary.

Irrevocable vs. revocable beneficiaries

You cannot change an irrevocable life insurance beneficiary designation without the beneficiary’s approval. For this reason, irrevocable designations aren't common. However, they can be useful if you want to make sure the death benefit reaches a specific person, such as your child.

In contrast, a revocable life insurance beneficiary designation is flexible. You can change, update, add or remove a revocable beneficiary at any time. This grants you the freedom to update your designation to match your current needs.

This decision isn't always a simple one. The right choice may not be the most obvious choice. Start by asking yourself why you have life insurance in the first place:

• Who relies on you financially and would need help paying ongoing bills if you die?
• Who would need financial support to cover costs incurred by your death, such as funeral expenses?
• Who would you like to leave money to regardless of whether they rely on you, such as a charity or a trust for your children?

You can avoid simple mistakes when designating a life insurance beneficiary by being as specific as you can. Make sure to include any identifying factors, such as each beneficiary’s full name, Social Security number, relationship to you, date of birth, and address, so the insurer can locate your beneficiaries quickly. Consult with a legal professional to ensure you use the correct language.

Once you narrow down your options, ask yourself how much money each beneficiary would need, and divide the death benefit accordingly.

Frequently asked questions