How life insurance payouts work
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Carrying a life insurance policy can be a good way to protect your assets and assist your family financially even after you are gone. But what exactly happens when an insured does pass away? How do beneficiaries access the death benefit or the policy value? Where are the funds sent and what happens to the policy? Bankrate’s insurance experts help you understand how life insurance payouts work.
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.
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
The payout for a permanent life insurance policy, such as whole life insurance, is a bit more complicated. A whole life policy also includes a savings component called cash value that the policyholder can draw from during their life. While the cash value of this type of life insurance policy will not be available to the beneficiary, it’s important to note that any money borrowed from the cash value of the life insurance policy and not repaid will be subtracted from the death benefit. If it is a $500,000 whole life policy and $10,000 was borrowed to start a business, the beneficiary will only receive $490,000 unless the $10,000 is repaid before the policyholder dies.
Types of life insurance payouts
There are several ways a beneficiary can receive the death benefit from a life insurance policy. The most common payout type is the lump sum payment. As the name indicates, this is a single payment, usually in the form of a check, that is given to the beneficiary once the amount has been approved by the insurer. That single payment would be for the entire amount of the death benefit, minus any outstanding loan amounts, if applicable.
The beneficiary may also be able to choose an installment payment of the death benefit, usually in the form of an annuity. An annuity is the periodic payment of a sum of money over an extended period of time. Some beneficiaries prefer annuities as a way of receiving a continuing income for a longer period of time.
A third option allows the insurer to function like a bank account, holding on to the death benefit until it’s needed. The insurer would issue a checkbook to the beneficiary, so they could draw on the money as needed.
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.
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 the death benefit payment due to an insurance review and potential ongoing criminal investigation.
Once everything is approved, you must decide how you would like to receive your payout. The lump sum payout option is by far the most common. Since there are no restrictions on what the money can be used for, a lump sum may help you achieve financial goals such as:
- Paying off a mortgage
- Saving for college tuition
- Paying down consumer debt
- Saving for retirement
- Creating an emergency fund
Generally, a life insurance death benefit is not taxable. However, there are specific situations where the benefit could be taxed, depending on the amount of the benefit and whether the benefit accrues interest. Certain states may also have laws regarding estate taxes if the amount is particularly high. Prior to deciding what to do with a death benefit payout, it may be helpful to contact a financial advisor to discuss any potential tax consequences and to review the best financial options available to you.
Frequently asked questions
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 mortgage debt, and your family’s monthly expenses. Many financial experts recommend an amount of life insurance equal to 5-15 times your annual salary. The Bankrate Life Insurance Calculator can help you get started.
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, as long as you pay your premiums. It’s more expensive than term insurance, but in addition to the death benefit, it features a savings component that allows you to borrow from your policy after a specified amount of time has passed.
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, a good financial expert can help you weigh the pros and cons of each option, including any potential tax ramifications.