With life insurance, when the insured dies, the beneficiary receives one large payout check equal to the death benefit of the policy.
But does it always have to be that way?
A one-time lump sum payment is the most common, but there are quite a few different settlements options that dictate how the beneficiary receives the funds.
Depending on the policy and company, these options may be set ahead of time by the policy owner or chosen by the beneficiary at the time of the passing of the insured.
We’ll start with the most typical and then break down all the different ways in which life insurance policy proceeds can be paid out.
Table of Contents
- Lump Sum
- Specific Income
- Interest Income
- Life Income
- Life Income with Period Certain
- Joint and Survivor
- Life Refund
- Fixed Period
- Other Settlements
- Tax Implications
The 8 Most Common Life Settlement Options
Listed alphabetically, below are the most common options you would have for a life insurance settlement payout which is not a lump sum payment.
1. Lump Sum
The beneficiary receives all the month up front, shortly after the death claim has been processed. This allows them to do with the money whatever they please, no strings attached and not subject to income tax.
Often times the funds will be used to pay off a large debt such as a mortgage and handle burial and other final expenses of the recent deceased insured.
If there is money left over, the beneficiary may choose to invest it on their own or to help replace a potential lost income.
In the case of permanent and universal life policies where loans against any built up cash value are permitted, if there is an outstanding loan, the payout amount will be reduced to pay that off first.
Example: A $500,000 death benefit will be paid in one payment of $500,000.
2. Specific Income
If you choose the Specific Income Option, you will get a fixed amount of income each year until the funds are exhausted. With this option, you do collect interest as well on whatever money is not yet paid out.
The eventual amount you receive will, therefore, be greater than the death benefit. Interest will be taxed as income.
Example: On a $500,000 death benefit, the beneficiary may choose to receive $50,000 per year. They will receive the same $50,000 for at least 10 years. The interest accrued will allow the payment to continue beyond 10 years.
3. Interest Income
This is for people who don’t have a need for a large amount of cash at the moment.
The full death benefit payout will remain with the life insurance company and they will make interest-only payments on it. These payments will be subject to income tax.
This option allows people to take some time to decide what they wish to do with the money. It could be a fit for someone who knows they have a large need down the road and wants to keep the money safe and untouched.
This can also be a way of creating a new life insurance policy.
If the initial beneficiary doesn’t need the funds, they collect the interest payments and designate the larger payout to a secondary beneficiary, therefore, creating a policy on themselves.
Example: With the $500,000 death benefit, the beneficiary receives 5% interest annually which equals $25,000 per year. They still access to the $500,000 down the road.
4. Life Income
Here you are choosing to receive payments for life.
Instead of a big chunk of money at once, the beneficiary can lock in a guaranteed income stream as long as they live.
The amount of the payout will be determined and offered by the insurance carrier. It will be based on the face value of the policy and the age of the beneficiary at the time payments start.
You may “win” or “lose” with this choice in terms of the ultimate amount of proceeds received.
If the person receiving the guaranteed income dies earlier than expected, the insurance company will cease payments. These do not pass on to a secondary beneficiary.
However, if they exceed the life expectancy, it’s possible that in the long run significantly more money is paid out to the beneficiary.
Example: A 42-year-old male decides not to take the $500,000 death benefit and instead chooses lifetime payments. He may receive in the neighborhood or $2,050 per month for life, for example.
5. Life Income with Period Certain
This is a variation of the Life Income option that adds a guaranteed amount of time the payments will be made even if the beneficiary dies early.
The guarantee means that unlike a typical “for life” option where payments stop at death, in this case, the secondary beneficiary would receive those payments until that period of time has been reached.
Because of this guaranteed time frame, the payments will be slightly lower.
Example: 42-year-old male chooses income for life on the $500,000 death benefit. He also locks in a guarantee of 20 years. The payments will likely be just above $2,000 per month.
6. Joint and Survivor
This is the same as the above Life Income option except that the lifetime payments continue for a spouse and don’t stop until the second person dies.
Because of this, expect the monthly payment to be slightly lower to account for the likelihood the payments will go on for a longer period of time.
Example: A 42-year-old male and his 42-year-old wife choose lifetime payments on the $500,000 death benefit. They may receive around $1,850 per month until both have passed away.
7. Life Refund
In this case, the payments will continue only up until the time the full death benefit is paid off.
The trade-off for not receiving any interest is that should the beneficiary die before the amount is reached, the balance will go to a secondary beneficiary.
Essentially, it’s a way to guarantee that the full death benefit does get paid out one way or another. This is in contrast to some of the life income options where payments cease once the beneficiary dies.
Example: On the $500,000 death benefit, the beneficiary decides to take $4,000 per month. After 7 years, they pass away. They have received a total of $336,000 in payments. The remaining $164,000 passes to a secondary beneficiary.
8. Fixed Period
When a Fixed Period is chosen, the death benefit is paid out over a specific period of time such as 5, 10, or 15 years. Interest will typically be added as well and that portion will be taxable.
This is a good choice for someone who wants the payments spread out but needs larger payments than a life option would give them.
Should the beneficiary die before the pre-determined period is up, the remainder will typically pass to a secondary beneficiary in a lump sum.
Example: 42-year-old male selects a 10 year fixed period on the $500,000 death benefit. He will receive somewhere around $4,750 per month for 10 years totaling around $575,000. The $75,000 in interest that was received above the initial $500,000 will be taxable income.
When to Choose a Life Settlement Other than Lump Sum
There are several reasons a policy owner or beneficiary may choose a different way to have proceeds paid out other than the normal one-time payment.
- Concern over their beneficiaries being irresponsible and blowing a large chunk of cash.
- Savings on premiums that may be offered by choosing a form of deferred payments. This has been popular at some companies such as Protective.
- Does not need the full payout right now and would rather it be spread out over time.
- On a fixed budget and want to a guaranteed a set amount of income for life.
- Has a concern about the risks and complexity of investing on their own.
Whether taken all at once or over time, the full amount of the death benefit is not typically subject to income tax. Any amount above and beyond that which results from interest earned will be taxable.
The exceptions to the rule on taxing the death benefit come when the policy was purchased by a company on the insured and can, therefore, can be considered compensation.
You want to get the most out of your life insurance policy. There are plenty of choices available on how life insurance death benefits will be paid out, and some are more advantageous than others.
Every company is a little different in what they offer, too.
It’s worth finding out up front about the choices you may have when purchasing a policy and the choices your beneficiaries will have down the road. This will help you meet every possible need in the future, regardless of how a situation might change.
A qualified life insurance professional can help guide you and answer any questions.