Life Insurance Death Benefit Proceeds: 6 Settlement Options That Beneficiaries Should Know
12 MIN READ
Published November 17, 2023 | Updated January 10, 2024
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A life insurance settlement payout can provide financial security if you lose a family member, partner, or spouse. Life insurance beneficiaries can use the amount to cover necessary costs, such as funeral expenses, normal living expenses for the family (for months or even years in the future), college tuition, and a down payment on a house.
There are several options when it comes to life insurance payouts. It's helpful to know your choices in advance so you can make an informed decision that supports your financial situation.
We also recommend speaking with a licensed insurance representative or a Certified Financial Planner (a CFP-certified advisor) for professional money management advice.
What Is a Life Insurance Settlement?
Life insurance can help provide financial freedom and income replacement for your beneficiaries, before and/or during their retirement years. It is also widely used in estate planning to pay any Estate Taxes that may be due or to create a tax-free inheritance for your family members. The death benefit proceeds of your insurance policy is paid out to your beneficiary(ies), shortly after you pass.
The payout of this death benefit is known as a life insurance settlement, and it can come in various forms. For example, your life insurance beneficiary can choose to receive it as a lifetime stream of monthly payments, as a single lump sum, or via some other type of structured payout.
The policy owner can choose the structure of the settlement ahead of time, but the policy may also allow the beneficiary to change it, after the insured person passes away. This is usually an option for the beneficiary when the policy owner and the insured are the same person.
How Does a Life Insurance Settlement Work?
When a person who is insured under any life insurance policy dies, the beneficiary receives the death benefit. Life insurance policy owners have to designate at least one primary beneficiary by name.
A life insurance beneficiary can be a person, a trust, a business, or even a qualified charity. The policy owner may also name contingent beneficiaries, who would receive the death benefit if one or more of the primary beneficiaries predecease the policy owner.
If you’re a beneficiary, you must file a claim, in order to collect the death benefit. There’s no time limit for claiming life insurance proceeds, but it’s best to start the process as soon as possible to ensure it goes smoothly. You’ll typically need to fill out the insurance company’s claim forms and submit a copy of the insured person’s death certificate to claim the benefit.
During the claim process, you may be able to choose from different settlement options. Once you submit the claim, the life insurance provider will process it, and you’ll receive the payout. States usually require life insurance companies to review, and fully pay a properly-submitted claim within 30 days of when it is received.
6 Common Life Insurance Settlement Options
There are many common life insurance settlement options that insurance companies typically offer. In some cases, you may also be able to customize your payment structure to receive funds annually, quarterly, or monthly.
1. Lump-Sum Payment
A lump-sum payment is one of the most common and well-known life insurance settlement options. With this option, the beneficiary will receive the entire benefit amount as a one-time, tax-free payout.
This will provide the beneficiary(ies) with full access to the money, which they can use for any purpose they wish, including using it to pay off debt or save more for retirement.
When To Choose This Option
Typically, the lump sum payout option is more appealing and often the best option for younger beneficiaries because it provides them more flexibility over how to use the money and more time over which the money can grow if it’s invested.
Choosing this option also makes sense when you’re fairly confident that your beneficiary is financially responsible, understands why money management is important, and can be depended on to put the funds to good use or invest it.
2. Interest Only
With an interest-only settlement option, the life insurance issuer will hold the death benefit principal amount and pay the beneficiary the interest that is earned on it, according to the current market interest rate the insurance company is offering. Beneficiaries can usually take partial or full withdrawals if they need more money at some point in the future.
When To Choose This Option
The purpose of this settlement option is to provide a consistent income stream through interest payments to the beneficiary while allowing the principal to stay safely and conservatively invested with the insurance company, yet still available to the beneficiary, if needed.
We recommend using this option if the beneficiary is young, financially inexperienced, or only needs a small income amount to support their lifestyle.
3. Interest Accumulation
In this option, there is no payout at all. Instead, the life insurance company will hold the funds on behalf of the beneficiary, and invest it very conservatively. The interest earned on the principal is added to the balance.
When the beneficiary needs access to the funds, they can take a withdrawal of the accumulated interest at any time. It’s important to note that, regardless of whether the beneficiary receives the interest or lets it accumulate in the account, any interest is taxable as income to the beneficiary.
When To Choose This Option
Choose an interest accumulation option if the beneficiary doesn’t need immediate access to the funds and wants to keep it secure for emergencies. We also recommend confirming with the life insurance company that the funds will be invested so the principal is protected, yet earns a competitive interest rate.
4. Fixed Amount
With a fixed amount life insurance settlement option, the beneficiaries will receive a fixed monthly payment until the benefit principal and earned interest are depleted. In some cases, beneficiaries may be able to increase or reduce the monthly amount they receive. If the payment is too high, the money can run out quickly, so it’s best to spend this money wisely to ensure a longer timeline for these guaranteed fixed payments.
When To Choose This Option
This settlement format is suitable when your beneficiary needs financial help only for a short period of time to support living expenses, such as when they’re in college or just starting their career.
5. Lifetime Income (Also Known as Life-Only or Life Annuity)
Lifetime income or life-only payments ensure beneficiaries receive payments that last the rest of their lives. This option ensures that you won’t spend the entire death benefit at once and will provide you with a regular fixed, monthly income stream for life, regardless of how long or short your life turns out to be.
During the first several years, these payments will consist of a combination of the tax-free death benefit and the interest earned on that money, so a portion of your total annual payments will be taxable as income, while the majority of it will be tax-free each year.
Once enough time passes, and these payments have dispersed 100% of the tax-free principal to you, the payments may become fully taxable as interest income for you, going forward. Generally, if you choose this option, you won’t be able to make any additional withdrawals or change the payments once you begin receiving these payments.
When To Choose This Option
Choose this settlement option when you want a reliable source of income that’s paid-out to you consistently each month, similar to the way Social Security or a company-provided pension would.
Because the payment amount is based on your current age and estimated life expectancy, older beneficiaries will receive larger payments for a shorter amount of time, while younger beneficiaries will receive smaller payments for a longer time period.
We recommend lifetime income for older beneficiaries because the larger payments will help support retirement income.
6. Lifetime Income With Period Certain
This option will provide a guaranteed income for life, but with the added benefit of a guarantee of receiving these payments for a minimum number of years, even when the beneficiary dies early.
For example, if you choose a life annuity with a 15-year period certain, you’ll receive income for life. But, if you happen to die five years after the payout starts, your beneficiary (whom you will designate ahead of time) will receive the same monthly payments for another ten years.
The longer your period certain, the lower your monthly payment will be. Periods of five to 20 years are common, and the same as with the life-only option, a portion of each payment you receive will be interest that is subject to income tax.
When To Choose This Option
This option may be suitable if you don’t need a larger amount of money but want a guaranteed payout period, to support a fixed expense, like a mortgage. It is also a good option for those who want to ensure that their beneficiaries will continue to receive payments in the event of their death.
Can You Cash Out or Sell Your Life Insurance Policy While You’re Still Living?
If you need access to cash or can no longer afford to pay premiums, and you’ve already withdrawn as much of the policy’s cash value as you can, you may decide to ”sell” the future benefits provided under your life insurance policy to a third party, while you’re still living.
Life settlement, often referred to as a “viatical settlement”, is a process in which you can sell your insurance policy to a third party, for an up-front lump-sum payment. The sale price will be higher than the policy's cash surrender value but won’t be as high as the death benefit.
Depending on your policy details, your current health, and your life expectancy, you may be able to receive 20%-60% of the policy’s death benefit, in return for agreeing to your policy’s buyer (not your beneficiary(ies)) receiving the full death benefit, when you pass away. You can get the proceeds in a single lump-sum payment, and the funds can be used for any purpose.
“It’s important to note here, that although nearly all individual life insurance death benefit payouts are received tax-free, any interest or investment returns earned on that principal will be considered taxable as income during the year in which you earn it,” explains Brad Reichert, debt expert and founder and managing director of Reichert Asset Management LLC. He says this is often the case when receiving interest-only payments or under the interest accumulation options.
“When choosing the lifetime or life-only option, if you live long enough, there will be a point at which you will have received 100% of the tax-free death benefit proceeds, and the remaining payments will be fully taxable,” Reichert adds. “Therefore, if you are unsure about which option is best for you, it is always best to consult a qualified tax advisor or a Certified Financial Planner for advice before making a decision about how to receive your benefits as a beneficiary,” he suggests.
You’ll need to check with your life insurance company to see if your policy qualifies to be sold, in exchange for a life settlement. Also, buyers may prefer policies worth at least $50,000, for example, or policyholders over 65 years of age.
How To Start a Life Insurance Death Benefit Claim and Receive Your Settlement Amount
You need to start by submitting the claim to the specific life insurance company as soon as possible to ensure the process goes smoothly. If you’re managing the affairs of a loved one after their death, notify all beneficiaries at the earliest so they can start their own claim.
If you’re interested in selling your insurance policy in return for a lump-sum cash payment, think about whether you still need coverage and if you can find other ways to continue paying the premium. You can then get in touch with a licensed broker or viatical settlements firm, to put your policy on the market to get you the best possible price.