Life Insurance Payouts: What To Expect When You Receive Them

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 death benefit can be used by the beneficiary in different ways, such as paying off a mortgage, saving for college tuition, or paying down consumer debt. The payout process begins when the beneficiary notifies the insurer. The insurer will then review the claim and process the payout accordingly. It's important to note that the beneficiary will need to provide a death certificate and any other necessary documentation to initiate the payout. While the payout is typically processed within a month, there may be certain circumstances that result in delays. Understanding the life insurance policy and its payout process is crucial to ensure that beneficiaries can access the death benefit without any issues.

Naming beneficiaries

When buying life insurance, you can designate one or more beneficiaries. This can be a single person or multiple people, or it can be an entity such as a charitable organisation. You can choose to name a single beneficiary, or a primary beneficiary and one or more contingent beneficiaries. A primary beneficiary is a person who will receive a payout from the policy when the policy owner dies. A contingent beneficiary will receive a policy payout if something happens to one of the primary beneficiaries.

If the policy owner names more than one primary or contingent beneficiary, they can specify what percentage of the death benefit proceeds each will receive. It is important to note that while minor children can be named as beneficiaries, they cannot receive any benefits until they reach the age of majority based on state law. They would need a legal guardian to manage the funds.

Death benefits are not paid out automatically from a life insurance policy. The beneficiary must first file a claim with the life insurance company, which may be done online or by filing a paper claim. The beneficiary will need to submit a copy of the policy, a claims form, and a certified copy of the death certificate.

Lump-sum vs. instalment payments

When it comes to receiving life insurance money, there are two main options: receiving a lump sum or receiving instalment payments. Here's a detailed comparison between the two:

Lump-Sum Payment

This is the most common payout option for life insurance. The beneficiary receives the entire death benefit in one go, and it is usually tax-free. This option provides immediate access to the full amount, which can be crucial for covering significant expenses or debts. However, receiving such a large amount of money at once can be overwhelming, and it's up to the beneficiary to manage and make the money last. There may also be limits on how much can be deposited in a single account, so the beneficiary might need to spread the money across multiple accounts.

Instalment Payments

Beneficiaries can choose to receive the death benefit in instalments over a fixed period or for their lifetime. This option provides a steady income stream, making financial planning easier. Instalment payments can be set to a specific amount paid monthly, quarterly, or annually until the proceeds are depleted. However, any interest earned on these payments may be subject to taxes. Instalment payments can also be set up in different ways, such as receiving a portion of the lump sum and then monthly instalments, or splitting the sum assured into a death benefit lump sum and equal monthly instalments.

The choice between a lump-sum payment and instalment payments depends on the beneficiary's financial needs and preferences. If the beneficiary needs to pay off considerable debt quickly, a lump sum might be the best option. On the other hand, if the beneficiary wants a steady income stream to support their family over time, instalment payments or an annuity might be preferable. It's important to carefully consider the financial literacy and acumen of the beneficiary when making this decision.

Tax implications

In most cases, life insurance payouts are income tax-free for beneficiaries. However, there are certain scenarios where taxes may apply.

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, and the beneficiary will end up with a smaller payout. Withdrawals from the policy's cash value are also permanently reduced from the death benefit and may be subject to taxation if they exceed the amount of premiums paid.

If the death benefit accrues interest before being paid out, the interest portion is taxable as income. This is also the case if the beneficiary receives the payout in installments or an annuity, as any interest earned on these payments may be taxable.

In a situation known as the "Goodman triangle", where the policyholder, the insured, and the beneficiary are three different people, the death benefit may be considered a gift from the policyholder to the beneficiary, triggering a gift tax.

If the death benefits are paid to the policyholder's estate instead of a named beneficiary, the payout may become part of the policyholder's taxable estate, potentially subjecting it to estate taxes.

Additionally, if the policyholder's employer pays the premiums, the amount received by the beneficiary for their disability due to the employer's payments is reported as income.

When it comes to permanent life insurance policies, such as whole life insurance, the cash value component can be accessed by the policyholder during their lifetime. This cash value grows tax-deferred, but if withdrawn, it may be subject to taxation. Withdrawals up to the amount paid in premiums can generally be made tax-free, but withdrawals exceeding this amount will be subject to income tax.

Policy loans, where the policyholder borrows against the cash value, are generally tax-free. However, if the policy lapses before the loan is repaid, the policyholder will pay taxes on the outstanding loan amount.

If the policy is surrendered for cash, the policyholder will have to pay taxes on any gains earned on the cash value portion.

Selling the policy to a third party through a life settlement will result in income taxes on the amount received from the sale, and the death benefit will go to the third party instead of the original beneficiary upon the policyholder's death.

Cashing out a policy

Cashing out a life insurance policy is only possible if you have a permanent life insurance policy that has accumulated cash value. There are three main ways to do this:

Taking out a loan against your policy

This option allows you to borrow money from your policy at a lower interest rate than a bank loan, without a credit check, and without affecting your credit rating. Repaying the loan is optional, but if you don't, the outstanding balance will be deducted from your death benefit.

Withdrawing funds from your cash value

You can withdraw some or all of the cash value of your life insurance policy. Withdrawing does not require you to surrender your policy, but it will likely reduce the death benefit that your loved ones will receive. Withdrawals may be subject to income taxes if they exceed the amount you've paid into the policy.

Surrendering your policy

You can cancel your policy and take the surrender value cash payment. However, this option means you will no longer have life insurance coverage, and the cash you receive may be reduced by surrender fees and taxes.

It's important to carefully consider your options and the potential pros and cons before deciding to cash out your life insurance policy.

Using the money

Once you receive the money from a life insurance policy, there are several ways you can use it. Here are some options:

• Paying off a mortgage: Removing a significant debt like a mortgage can provide financial security and peace of mind.
• Saving for college tuition: Setting aside funds for a child's or grandchild's education can ensure they have the resources they need for their future.
• Paying down consumer debt: Reducing or eliminating credit card debt or other loans can alleviate financial burdens.
• Saving for retirement: Investing the payout in retirement accounts can help secure a comfortable future.
• Creating an emergency fund: Establishing a reserve for unexpected expenses can provide a financial safety net.
• Paying for funeral costs and other end-of-life expenses: Funerals and other end-of-life costs can be expensive. If you are taking time away from work to grieve, you might also need the money to cover lost income.
• Memorialising your loved one: You could donate some or all of the proceeds or create a scholarship fund in their honour. Alternatively, you could use the money for a family trip or reunion in their memory.

Frequently asked questions