Life Insurance Payouts: What Survivors Need To Know

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 types of life insurance, including term and permanent plans. When a policyholder passes away, their beneficiaries must file a claim with the insurance company, along with a certified copy of the death certificate, to receive the death benefit. The death benefit is usually paid out as a lump sum, but can also be paid in installments or annuities. Beneficiaries can use the money however they want and it is generally not subject to income tax.

Who receives the money?

The person or people who receive the money from a life insurance policy are called the beneficiaries. When you take out a life insurance policy, you can choose who your beneficiaries are. This can be one person, or there can be multiple beneficiaries. Beneficiaries can be individuals, such as a spouse, child, or other family members, but they don't have to be – you can also choose a non-family member, a trust, a charity, or an estate as your beneficiary.

In some cases, the beneficiary of a life insurance policy might be the insured person's spouse or another family member, but this is not always the case. For example, if the insured person wanted to leave money to care for other family members, such as parents or siblings, they could name them as beneficiaries. Similarly, if the insured person wanted to leave money to a family-run business, they could name the business as the beneficiary. In the case of survivorship life insurance, which covers two people under one policy, the beneficiaries are usually the couple's children or other heirs.

It's also important to note that beneficiaries can be changed. When you buy an insurance policy, you can designate each beneficiary as either revocable or irrevocable. Revocable beneficiaries can be changed relatively easily, but for irrevocable beneficiaries, you usually need their consent to remove them from the policy or change their share.

Finally, it's worth mentioning that, in the case of minor children, they cannot actually receive any benefits until they reach the legal age of majority. In the meantime, the funds would need to be managed by a legal guardian.

How much will they receive?

The amount of money that survivors will receive from a life insurance policy depends on several factors, including the type of policy, the financial goals and needs of the insured, and the number of beneficiaries. Here is a detailed look at how much survivors can expect to receive:

Types of Life Insurance Policies

Life insurance policies can be broadly categorized into two types: permanent and term. Permanent life insurance policies do not have an expiration date and provide coverage for life as long as premiums are paid. Many permanent policies also offer an investment component that allows the policyholder to build cash value by investing in the stock market or earning interest on their account. On the other hand, term life insurance only covers the insured for a set number of years and does not accumulate cash value. The duration of coverage under a term life insurance policy can vary, often ranging from one, ten, or twenty years. It is important to note that permanent life insurance policies are generally more expensive than term life insurance policies.

Financial Goals and Needs

When determining the amount of life insurance coverage needed, it is essential to consider the financial goals and needs of the insured. Life insurance proceeds can be used to pay off outstanding debts, including mortgages, car loans, credit card debt, and personal loans. The payout should ideally be large enough to cover these debts, with additional funds to settle any extra interest or charges. Life insurance can also serve as a source of income replacement for dependents, especially if the insured was the primary breadwinner. In such cases, it is recommended to have enough coverage to replace at least ten years of the insured's salary, taking into account potential inflation and unexpected costs. Additionally, life insurance can help cover funeral and burial expenses, as well as other final expenses such as estate taxes and administrative costs.

Number of Beneficiaries

The number of beneficiaries can also impact the amount each survivor will receive. A life insurance policyholder can designate multiple beneficiaries and allocate different percentages of the death benefit to each beneficiary. The policyholder has the flexibility to divide the death benefit in any way they choose, and it is not automatically divided equally among the beneficiaries.

When will they receive it?

When it comes to receiving the money from a life insurance policy, there are a few things to consider. Firstly, it's important to understand that life insurance benefits are typically paid out when the insured party dies. This means that the beneficiaries will need to file a death claim with the insurance company, usually by submitting a certified copy of the death certificate.

In most states, insurance companies have 30 days to review the claim after it has been filed. During this time, they can choose to pay out the claim, deny it, or request additional information. If the claim is approved, the insurance company will then pay out the benefit, which is typically done within 30 to 60 days of the date the claim was initially filed. This timeframe can vary depending on the company and the specific circumstances of the claim.

It's worth noting that there are certain situations that may result in a delay in payment. For example, if the insured person dies within the first two years of the policy being issued, there may be a delay of six to 12 months due to the contestability clause commonly found in life insurance policies. Additionally, if the death certificate lists homicide as the cause of death, the insurance company may need to communicate with the detective assigned to the case to rule out the beneficiary as a suspect, which can also cause a delay.

In terms of how the benefit is paid out, beneficiaries usually have several options to choose from, including a lump-sum payment, installment payments, annuities, or a retained asset account. A lump-sum payment is the most common option, where the beneficiary receives a large amount of cash to use as they please. Installment payments allow the beneficiary to receive the benefit in a series of payments over time, with the insurance company holding the money in an interest-bearing account. Annuities provide a stream of income payments created from the money used to purchase the annuity, while a retained asset account allows the beneficiary to write checks against the balance held by the insurance company.

It's important to remember that the process of receiving life insurance benefits can vary depending on the company and the specific policy in question. Therefore, it is always advisable to carefully review the terms and conditions of the policy and consult with a financial professional or insurance agent for guidance.

What are the tax implications?

Life insurance death benefit payouts are usually not taxable. This means that beneficiaries will receive the money without having to pay taxes on it. However, there are certain situations where a life insurance death benefit may be taxable.

If you are a life insurance beneficiary who receives interest on a death benefit, this interest may be taxed. Most life insurance payouts are made in one lump sum right after the death of the insured person. However, if a beneficiary chooses to delay the payout or take the payout in instalments, interest may accrue.

If the life insurance payout goes into a taxable estate, it may be subject to federal and state estate taxes. This could result in a significant tax bill, especially if the estate is already close to the exemption level and the large life insurance payout pushes it above the threshold.

In a situation where three people serve three different roles in connection with the life insurance policy (the policy owner, the insured, and the beneficiary), the life insurance payout may be considered a taxable gift by the IRS. This is known as the "Goodman triangle" or "Goodman rule". The policy owner may have to pay gift tax on the life insurance payout if it exceeds federal gift tax exemption limits.

While life insurance death benefits are generally not taxable, there may be tax implications on the cash value of a life insurance policy. If you have a cash value life insurance policy, such as whole life insurance, you can access the money by making a withdrawal, taking out a loan, or surrendering the policy. The money within the cash value account grows tax-free, but once you withdraw it, you may have to pay taxes on any interest or investment gains.

If you surrender a cash value life insurance policy, you will be taxed on any amount you receive above the policy basis, which is the total premium payment you made on the policy. Similarly, if you take out a loan against the cash value and the policy terminates before you repay it, you will be taxed on the amount of the loan that exceeds the policy basis.

In most cases, life insurance premiums are not taxable or deductible on your tax return. However, if you have group term life insurance and the death benefit is more than $50,000, the premiums paid by your employer may be subject to income tax.

What if the policyholder dies during the policy term?

If the policyholder dies during the policy term, the beneficiaries or nominees can claim the life insurance policy. The death benefit is the money paid out to the beneficiaries, which can be a lump sum or paid in other ways. The policyholder can choose who their beneficiaries are, and these are usually family members, but can also be non-family members, charities, or other entities. The policyholder can also decide how the benefit is split between multiple beneficiaries.

It is important to keep beneficiary details up to date to avoid legal issues. If a beneficiary passes away during the policy term, the nomination becomes null and void, and the policyholder can change the nomination. If the beneficiary dies after the policyholder's death but before receiving the claim, the amount will be paid to the beneficiary's legal heirs.

Frequently asked questions