The whole point of having life insurance is to protect the policy beneficiaries (such as family members or loved ones) when the insured dies.
But exactly how does a life insurance payout work?
If you are the beneficiary on a life insurance policy, it means that when the life insurance policyholder dies, you will receive either a partial or total amount of the policy’s death benefit, also known as the policy’s face value.
If you are one of several beneficiaries, the policy will dictate how much of the life insurance proceeds you receive.
If you are the sole beneficiary, then you will receive the entire death benefit outright.
It is important to know the bureaucratic procedures that you must follow to get your money after a loved one passes.
Death – The First Step
A whole life insurance policy remains in force as long as the insured is living and someone is paying the life insurance premiums (unless the policy is paid up).
A term life insurance policy remains in force as long as the insured is living for the duration of the term, and then it will expire.
When the insured dies, both permanent and term life policies pay out their face values to the beneficiary or beneficiaries named in the policy.
If you are unfamiliar with these different insurance products, read this guide to types of life insurance policies.
The Death Claim
After the policyholder passes, the beneficiaries must procure a copy of the insured’s death certificate and file a death claim in the state of residence of the deceased.
Most life insurance companies will also require you to file a benefits claim with them before they will release the money. A life insurance claim can be a complex set of documents that detail the manner and cause of death, as well as other details that the insurance agency may need to know to pay the correct death benefit.
Say, for example, that the insured purchases a policy rider that doubles the death benefit if the insured dies in an accident. Years later, the insured dies in an accident. There will be a section in the benefits claim paperwork requiring beneficiaries to specify the nature and cause of the accident; and whether the insured could be either partially or totally at fault. If no fault is found, then the policy will pay twice the face amount per the policy rider.
The death benefit can be adjusted up or down, depending upon the terms of the policy and the riders contained in the policy. The information on the benefits claim paperwork determines the final payout amount.
If the insurance company has further questions about the nature of the insured’s death, they may start their own investigation into the circumstances surrounding the death. They may obtain additional information such as police and medical reports and other official sources of data before deciding on whether, or how much, to pay on the death claim.
For example, if the insured dies while committing a crime, then the insurance company may deny the payout even though all other conditions are met. It all depends upon the specific rules of the insurance company and state laws.
The processes involved in claiming a death benefit may take a long time. Be sure to contact the life insurance company immediately following the death of the insured to get the ball rolling. You should have the original death certificate on hand (preferably along with a few certified copies), the original application with the policy number, and the benefits claim form on hand when you contact the insurance provider.
It usually takes life insurance companies anywhere from 30 to 60 days to process a claim.
Processing a claim can take much longer if the insurance company does not receive all documentation, or if the insurance company launches an investigation. The maximum length of time varies by state.
The Two-Year Contestability Period
If the insured dies within the first two years of the life of the policy, then the insurance company may choose to delay the death benefit payout until the full two years have elapsed.
So if someone takes out a policy and dies six months later, the beneficiaries may have to wait another 18 months before receiving the death benefit.
Since death happened so soon after the policy was purchased, the insurance company may investigate to determine whether the insured took out the policy with the intention of committing fraud.
There is often a suicide clause that coincides with the two-year contestability clause. A suicide clause states that the insurance company does not have to pay the death benefit if the insured commits suicide within two years of taking out the policy.
The Death Benefit Payout
Life insurance companies often take their time when processing death claims to ensure that the beneficiary genuinely deserves the death benefit and that no fraud has been committed. You may have to wait months to get your money, especially if the circumstances surrounding the death of the insured are complex and ambiguous.
Once a decision is reached, beneficiaries can expect to receive their money in anywhere from a couple of weeks to 45 days.
State laws usually specify the maximum amount of time that can elapse before the life insurance company must send you your check. The life insurance company will usually send the funds in the form of a bank check unless the beneficiaries previously specified a direct deposit option and given the insurance company the necessary bank information.
Who Gets the Payout
Anyone listed as a beneficiary is legally entitled to either some or all of the death benefit.
To be named a beneficiary, the insured has to list you as the sole or partial beneficiary while they were living.
Once the insured dies, the beneficiary status becomes irrevocable. That is, no one can be named as a new beneficiary once the insured is gone.
The insured only has to name one primary beneficiary, but can also designate a secondary beneficiary if need be.
Unlike policyholders, beneficiaries do not need to take a medical exam or get life insurance quotes to get paid.
Life Insurance Payout Options
You may assume that the only way that the insurance company will pay you is with a single lump-sum payment. This is not the case.
There is a range of payout options to choose from, and the right choice depends upon your needs and objectives.
Here are the 6 main life insurance payout options:
Lump-Sum – This is the simplest form of payout and settles the account with the insurance company with a single deposit.
Installment Payments – Also known as a systematic withdrawal, this is where the life policy pays out the death benefit in installments, such as 20% of the full death benefit amount every year for five years. The beneficiary usually earns interest on the unpaid amount while the insurance company still holds it.
Straight Life Income – The life insurance company will make periodic payments that are guaranteed to last for the rest of a beneficiary’s life, no matter how long that person lives. This long-term amount can be paid on a monthly, quarterly, or annual basis.
Life Income with Period Certain – One of the big disadvantages of a straight life payout is that if a beneficiary dies soon after the payout begins, then the insurance company will keep the remainder of the money. Therefore, a “period certain” guarantees that payments are made for at least a certain period of time, such as for 20 years after the death of the insured. That way, if a beneficiary dies five years later, their contingent beneficiary would receive payments for another 15 years.
Joint Life with Survivorship – This form of payout is calculated on the lives of two people and continues to pay out as long as one of them is living. A period certain can also be added on to this form of payout. (It should be noted that joint and period certain payouts are less than straight life payouts because of their guarantees.)
Interest Only – This allows the life insurance company to keep the life insurance benefits and pay the beneficiary the interest generated from the principal amount.
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Tax Rules for Payouts
The tax rules for life insurance payouts are straightforward. All death benefit proceeds are unconditionally free from income taxes, regardless of when the death benefit is paid, who receives it and how it is used.
This is true for all of the payout choices listed above. There is one possible exception: when a business or corporation purchases life insurance on one or more employees for business purposes. In this instance, some or all of the death benefit may become taxable depending upon certain circumstances. But aside from this, any money received from a personal policy is tax-free.
However, any interest generated from the principal in the policy is usually taxed to the beneficiary as ordinary income, which means that a recipient pays tax on that money at their top marginal tax rate.
For example, if you elect to receive your $100,000 death benefit in five equal payments over five years, then you would pay tax on the interest generated by the remaining $80,000 during the first year, the remaining $60,000 the second year and so on until your entire death benefit is paid. But you will not pay income tax on the principal.
While death benefit proceeds are not subject to income taxation, they can be subject to estate taxation. If you are lucky enough to receive a $20 million death benefit, then a good chunk of that may be subject to an estate tax, unless the policy was housed inside an irrevocable life insurance trust for at least three years prior to payout.
If your death benefit is significant enough to trigger estate tax issues, enlist the help of an estate planning attorney and financial advisor or financial planner versed in large life settlements to help you navigate through the complexities of this situation.
Using Life Insurance Payout Proceeds
There is no single right way to use the death benefit of a life insurance policy.
If you are deep in debt, then you may choose to use some or all of it to pay off your obligations, especially if they are charging you a high rate of interest.
Or, you may choose to invest some or all of your death benefit in an investment portfolio. The right portfolio for you depends upon your risk tolerance, investment objectives, and time frame.
If you want to use the money to save for retirement, consider opening a Roth IRA and making annual deposits that can grow tax-free for the rest of your life.
If you have a higher risk tolerance and you won’t need to spend the money any time soon, then a stock or stock mutual fund portfolio may be a good idea.
If you want current income from your money, then bonds and bond funds would be appropriate. You may be able to generate more interest from your own portfolio than the insurance company would pay you, depending upon interest rates and other factors. Don’t be afraid to talk to a few different investment advisors to see what kind of portfolio would be best for you.
The larger the death benefit, the more investment choices you have, and the greater the amount of investment income you could generate.
If you would like market growth while protecting your principal, then an equity-indexed annuity may be right for you. This type of vehicle pays interest into your contract based upon the performance of an underlying financial benchmark, such as the S&P 500 Index, instead of at a fixed rate. But unlike investing in a traditional fund, you cannot lose money in it when the markets go down. And you will likely earn more in this type of annuity over time than you will in a fixed annuity.
Collecting the death benefit from a life insurance policy is a relatively straightforward process in most cases. However, if there is any question surrounding the circumstances of the insured’s death, the investigation may drag on for months or even years.
Be sure to have all of the necessary documentation ready when you file your death claim, and consult your financial advisor or life insurance agent for more information on life insurance payouts.