The whole point of having life insurance is to protect the policy beneficiaries (such as you or other loved ones or family members) when the insured dies. But exactly how does this happen?
If you are the beneficiary on a life insurance policy, it means that when the insured on the policy (which may be a parent or other relative) dies, you will receive either a partial or total amount of the policy’s death benefit, or face value. If you are one of several beneficiaries, the policy will dictate how much of the life insurance proceeds goes to you. If you are the sole beneficiary, then you will receive the entire death benefit outright. But it is important for you to know the bureaucratic procedures that must be followed in order for you to get your money so that there are no mistakes or delays.
- The First Step
- The Death Claim
- Viatical Settlement
- Two Year Contestablility
- The Payout
- Who Gets the Payout?
- Payment Options
- Tax Rules
- Using the Proceeds
Death – The First Step
A cash value life insurance policy will remain in force as long as the insured is still living and premiums are being paid (unless the policy is paid up). A term life insurance policy will remain in force as long as the insured is still living for the duration of the term, and then it will expire. But when the insured dies, both permanent and term life policies will pay out their face values to the beneficiary or beneficiaries named in the policy.
The Death Claim
In order for this to happen, the beneficiaries must procure a copy of the death certificate of the insured 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. This can be a fairly complex set of documents that detail the manner and cause of death of the insured as well as other details that the insurance company may need to know in order to pay the correct death benefit.
Say, for example, that the insured purchased a policy rider that would double the amount of the face value if the insured were to die in an accident (and then the insured does die this way). There will be a section in this paperwork requiring you 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 you twice the face amount.
The death benefit can be adjusted either upward or downward, depending upon the terms of the policy and the riders contained in the policy. The information that you put on the benefits claim paperwork will determine the final amount that is paid. If the insurance company has further questions about the nature of the insured’s death, then they may start their own investigation into the circumstances surrounding the death. They may obtain information such as police and medical reports and other official sources of data before making a decision on whether, or how much to pay on the death claim.
For example, if the insured died while committing a crime, then the insurance company may deny the payout even though all other conditions have been met. It all depends upon the specific rules of the insurance company and state laws. Whatever you do, be sure to contact the life insurance company immediately following the death of the insured in order 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 call them.
It usually takes life insurance companies anywhere from 30 to 60 days to process a claim, provided that they have all the documentation that they need and do not launch an investigation into the claim. The maximum length of time varies by state.
The Two-Year Contestability Clause
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 your dad takes out a policy on you and dies 6 months later, then you may have to wait another 18 months before you will get your money. And because the death happened so quickly, the insurance company may also conduct an investigation to determine whether the insured took out the policy with the intention of committing fraud. The 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.
Life insurance companies will often take their time when processing death claims in order to ensure that the beneficiary genuinely deserves the death benefit and that no fraud has been committed. You may have to wait for months to get your money in some cases, especially if the circumstances surrounding the death of the insured are complex and ambiguous.
But once a decision has been reached, you can expect to receive your 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 you the funds in the form of a bank check, unless you have previously specified a direct deposit option and given the insurance company your bank information.
Who Gets the Payout
As the beneficiary (or one of them), you are legally entitled to either some or all of the death benefit that is to be paid by the policy. In order to be named as such, the insured had to list you as the sole or partial beneficiary while he or she (or 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 name a secondary beneficiary if need be. And unlike the insured when the policy was purchased, you will not need to take a medical exam or get life insurance quotes in order to get paid.
You may assume that the only way that the insurance company will pay you is with a single lump-sum payment. This is most definitely not the case. There are a range of payout options that you can choose from, and the right choice for you will depend upon your needs and objectives. The main options to choose from include:
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 5 years. The beneficiary usually earns interest on the unpaid amount while the insurance company is still holding it.
Straight life income – The life insurance company will make you a periodic payment that is guaranteed to last for the rest of your life, no matter how long you live. 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 you die soon after the payout begins, then the insurance company will keep the remainder of the money. Therefore a period certain guarantees that payments will be made for at least a certain period of time, such as for 20 years after the death of the insured. That way, if you were to die 5 years later, your 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 will continue 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 this principal amount.
Tax Rules for Payouts
The tax rules for life insurance payouts are very simple. 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 that is generated from the principal in the policy is usually taxed to the beneficiary as ordinary income, which means that they will pay tax on that money at their top marginal tax rate. For example, if you elect to receive your $100,000 death benefit in 5 equal payments over 5 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 has been paid. But you will not pay income tax on the principal.
And 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 the estate tax, unless the policy was housed inside an irrevocable life insurance trust for at least 3 years prior to payout. (If your death benefit is large enough to trigger estate tax issues, then you would need to promptly enlist the help of an estate planning attorney and financial advisor who is versed in large life settlements to help you navigate through the complexities of this situation.)
Using the Proceeds
There is no single right way to use the death benefit of a life insurance policy once you receive it. 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 will depend upon your risk tolerance, investment objectives and time frame. If you want to use the money to save for retirement, then consider opening a Roth IRA and making annual deposits into it 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. And 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 you could use.
The larger the death benefit, the more investment choices you will 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 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.