How life insurance payouts work

As you get older and have more responsibilities, it’s common to wonder what will happen after your passing and how you will be able to support your family in your wake. Having a life insurance policy is one way to provide financial security after your death. Life insurance policies offer a payout known as a death benefit, but how much is paid out and under which circumstances depends on the type of policy that you have. Understanding your policy type and its life insurance payout is important to ensure that your beneficiaries are able to access the death benefit when it matters most.

Understanding life insurance payouts

Before getting into the details of the death benefit and how the money is distributed, it is important to understand how life insurance policies are designed to be paid. When purchasing a life insurance policy, a policyholder needs to decide who will receive the death benefit. This person is called a beneficiary. How long the death benefit is available to the beneficiary will be determined by the type of life insurance policy. While a term life insurance policy remains active during a specific term for a set amount, a permanent life insurance policy is designed to be active throughout a policyholder’s life as long as premiums are paid.

Beneficiaries

One of the most important elements of the life insurance application process is the designation of a primary beneficiary or beneficiaries. This can be a single person or multiple persons, or it can be an entity such as a charitable organization.

You may also designate a contingent beneficiary. This person or entity is a secondary recipient of your policy payout. If your primary beneficiary dies before you do, the contingent beneficiary would receive your death benefit.

Term life insurance payouts

If you have a term life insurance policy, the coverage lasts for a certain length of time — such as 10, 20 or 30 years — and features a simple payout of the death benefit amount if you pass away during the policy’s lifespan.

Permanent life insurance payouts

Permanent life insurance policies, like whole life insurance, offer a payout process that includes additional complexities compared to term life insurance, primarily due to their cash value component. Here’s a breakdown to help you understand how life insurance pays out:

• Cash value component: Permanent life insurance policies build a cash value over time, which the policyholder can access during their lifetime. This cash value grows tax-deferred and can be borrowed against or withdrawn.
• Borrowed cash value: If the policyholder borrows from the cash value and doesn’t repay it, the amount borrowed plus any interest will be deducted from the death benefit.
• Withdrawn cash value: When you withdraw money from your policy’s cash value, it permanently reduces the death benefit. Unlike loans, withdrawals cannot be repaid to restore the death benefit.
• Dividends: Some mutual life insurance companies pay dividends to policyholders. These dividends can be used in various ways, such as buying paid-up additions (PUAs). PUAs are small amounts of additional life insurance that have their own death benefit and cash value, increasing the overall value of your policy. Using dividends to buy PUAs can therefore increase your beneficiaries’ death benefits over time.
• Graded death benefit period: For guaranteed issue policies, the full death benefit may only be available if the policyholder dies after a specific period, known as the graded death benefit period. If the insured dies within this period, usually, the beneficiaries receive a return of premiums paid plus some interest or a smaller percentage of the death benefit.

Explanation of loans vs. withdrawals

It can be easy to confuse loans and withdrawals from a permanent life insurance policy because both involve accessing the cash value. However, they impact your policy and death benefit in different ways. Here’s a clearer breakdown with examples:

Loans

When you borrow against your policy’s cash value, you’re essentially taking an advancement against the policy’s death benefit and using the cash value as collateral. This loan can be repaid while you’re alive, which restores the original death benefit. If it is not repaid, the loan amount plus any accrued interest will be deducted from the death benefit prior to your beneficiaries receiving any payout.

Example: Imagine you have a $500,000 permanent life insurance policy, and you borrow $10,000 to cover a medical expense. If you repay this $10,000 loan, along with any interest, your policy’s death benefit remains at $500,000. However, if you don’t repay the loan and you have accrued $1,000 in interest, your beneficiaries will receive $489,000 ($500,000 – $10,000 – $1,000).

Withdrawals

Some types of permanent policies permit withdrawals. When you withdraw money from the cash value, it is a permanent reduction in the death benefit. Withdrawals do not accrue interest and cannot be repaid to restore the original death benefit.

Example: Suppose you have a $500,000 policy and withdraw $10,000 to pay for a home repair. This withdrawal permanently reduces your death benefit to $490,000. There’s no option to pay back the $10,000 to increase the death benefit back to $500,000.

Riders can impact payouts

Riders are optional add-ons to a life insurance policy that provide additional benefits. They can also impact the final payout. Some riders can increase the death benefit or offer living benefits to the policyholder. For instance, an accidental death benefit rider could significantly increase the payout if the policyholder dies due to an accident. For example, a $500,000 policy with an accidental death benefit rider might double the payout to $1,000,000 in the event of an accidental death.

Other riders offer living benefits, allowing the policyholder to access a portion of the death benefit under specific conditions, which can reduce the final payout. Common living benefit riders include:

• Accelerated death benefit rider: This allows access to part of the death benefit if the policyholder is diagnosed with a terminal illness. For example, if a policyholder with a $500,000 policy is diagnosed with a terminal illness, they might access $100,000 to cover medical expenses, reducing the payout to beneficiaries to approximately $400,000.
• Chronic and critical illness riders: These provide funds if the policyholder is diagnosed with a chronic or critical illness. For instance, a policyholder with a $500,000 policy who suffers a severe stroke (a critical illness) or is diagnosed with Alzheimer’s disease (a chronic illness) might use $150,000 for medical and care expenses, reducing the death benefit to approximately $350,000.
• Long-term care (LTC) rider: This covers long-term care services, which reduces the death benefit accordingly. For example, if the policyholder uses $200,000 for long-term care from a $500,000 policy, the payout to beneficiaries would be reduced to approximately $300,000.

It’s important to note that having a rider on a policy doesn’t automatically mean it will be used. If the conditions for the rider are not met or if the benefits are not accessed, the death benefit remains unchanged, and beneficiaries receive the full face amount.

Types of life insurance payouts

Life insurance payouts can be received in various ways, offering flexibility to beneficiaries based on their financial needs and preferences. Here are the main types of payouts available:

• Lump-sum payment: This is the most common payout option. Beneficiaries receive the entire death benefit in one single, usually tax-free, payment. This method provides immediate access to the full amount, which can be crucial for covering significant expenses or debts.
• Installment payments: Beneficiaries can choose to receive the death benefit in installments over a fixed period or for their lifetime. This option can provide a steady income stream, making financial planning easier. The installments can be set to a specific amount paid monthly, quarterly or annually until the proceeds are depleted. However, any interest earned on these payments may be taxable.
• Retained asset account (RAA): This is an interest-bearing account where the insurer holds the death benefit and provides the beneficiary with a checkbook to draw funds as needed. This option offers flexibility and easy access to the funds while earning interest. However, the interest earned may be subject to taxes.
• Interest-only payout: With this option, the insurer keeps the death benefit and pays the beneficiary only the interest earned on the amount. The principal remains intact and can be passed on to other beneficiaries upon the original beneficiary’s death. This option provides regular income but may come with taxable interest.
• Lifetime annuity: A lifetime annuity provides guaranteed payments to the beneficiary for the rest of their life. The amount is determined by the death benefit and the beneficiary’s age. If the beneficiary dies before the death benefit is exhausted, the remaining amount typically reverts to the insurer.
• Fixed-period annuity: In a fixed-period annuity, the death benefit is paid out over a specified period, such as 10 or 20 years. If the beneficiary dies before the end of this period, their designated beneficiaries can continue to receive the remaining payments. This method ensures a regular income for a set time frame.

The life insurance payout process

The life insurance payout process is not complicated, but it does require the beneficiary to make some financial decisions and handle some paperwork. Here is what you need to do:

File the claim

As soon as possible after the policyholder’s death, contact the insurance company to find out their procedure for filing a claim. You will likely have to submit a certified copy of the death certificate and complete additional paperwork, such as a claim form. Although there is no deadline for filing a claim, it is wise to handle this as soon as possible. Your state will have laws that indicate how long the insurer has to review your claim once submitted — often 30 to 60 days.

Possible issues

If you file the claim properly and provide all the necessary documents, you will typically receive the death benefit payout of a life insurance policy within a month. However, there are rare circumstances in which delays might occur. The following situations could cause delays:

• Policy purchase date: Policies are typically contestable by the company for the first two years they are in effect, so if the policyholder purchased the policy recently, the insurer may have questions, as life insurance claims on new policies can be a warning sign of fraud. If the death was by suicide, benefits might be denied if there was a suicide clause in the contract.
• Suspected foul play: If the policyholder was murdered, there may be a delay as the insurance company works with police to ensure that the beneficiary was not involved in the crime.
• Fraud: If the policyholder lied on the application or if false information is discovered, the insurance company can typically do a thorough review to determine if the policy is valid, even after the contestability period ends. Some life insurance policies will have an incontestability clause written into the policy, so it’s important to review the policy with a licensed professional if you have questions.
• Policyholder killed during illegal activity: If the policyholder was killed while committing a crime, the insurer may delay or even deny the death benefit payment due to an insurance review and potential ongoing criminal investigation.

Common payout uses

One of the primary advantages of a life insurance death benefit is the flexibility it offers, as there are no restrictions on how the money can be spent. Common uses of the payout include:

• Paying off a mortgage: Eliminating a major debt like a mortgage can provide financial security and peace of mind.
• Saving for college tuition: Setting aside funds for a child’s or grandchild’s education can ensure they have the resources needed for their future.
• Paying down consumer debt: Reducing or eliminating credit card debt or other loans can alleviate financial burdens.
• Saving for retirement: Investing the payout in retirement accounts can help secure a comfortable future.
• Creating an emergency fund: Establishing a reserve for unexpected expenses can provide a financial safety net.

Are life insurance payouts taxable?

In most cases, life insurance payouts are income tax-free to beneficiaries. However, there are certain scenarios where taxes may apply:

• Interest income: If the death benefit accrues interest before being paid out, the interest portion is taxable as income.
• Goodman triangle: This situation occurs when the policyholder, the insured and the beneficiary are three different people. For example, if a mother (policyholder) takes out a policy on her son (insured) and names her husband the beneficiary, the death benefit can be considered a gift from the policyholder to the beneficiary. This may trigger a gift tax because the IRS views it as the policyholder (mother) giving a financial gift to the beneficiary (husband).
• Estate tax: If the death benefits are paid to the policyholder’s estate instead of a named beneficiary, the payout may become part of the policyholder’s taxable estate, potentially subjecting it to estate taxes.

Understanding these exceptions can help beneficiaries plan for any potential tax liabilities. Consulting with a financial advisor or tax professional can provide personalized guidance based on individual circumstances.

Frequently asked questions

• How much life insurance do I need?

  Determining how much life insurance you need will depend on what you hope to accomplish with your policy. Consider your long- and short-term debts, including a mortgage and your family’s monthly expenses. Many financial experts suggest 10 times your annual salary as a good starting point for consideration. Additionally, comparing different policy types can help you choose the best option for your needs, ensuring comprehensive coverage for your family. The Bankrate life insurance calculator can help you get started.
  

• What is the difference between term life insurance and whole life insurance?

  Term insurance, as the name suggests, lasts for a specific term of time. It’s a simpler form of insurance than whole life, and the beneficiary will only receive the death benefit if the insured passes away during the specified policy term. Whole life insurance lasts for your entire life (technically to a maximum age of 95 to 121) as long as you pay your premiums. It’s more expensive than term insurance, but in addition to the death benefit, it features a cash value component that allows you to borrow from your policy after a specified amount of time has passed.
  

• Is it better to take a lump sum payment or spread it out over time?

  That depends on your circumstances. If you have considerable debt you would like to pay off quickly, a lump sum might be best. If you are more concerned about having money to support your family over time, you may prefer an annuity. If you are uncertain, an experienced financial professional can help you weigh the pros and cons of each option, including any potential tax ramifications.
  

• What is the average life insurance payout?

  The average life insurance payout in the U.S. is about $168,000, according to Aflac. However, the payout of your life insurance policy will depend on the face amount (death benefit) you choose and any money accelerated, borrowed against or withdrawn from the policy prior to the payout.