How Life Insurance Payouts Work: Everything You Need To Know
Life insurance is designed to provide funds to loved ones when someone passes away. The funds can be used for virtually any purpose, but they are often used to address funeral and burial expenses and to replace the deceased person’s income in the household budget. However, life insurance beneficiaries often have different options when it comes to the actual life insurance payout, depending on the policy. Life insurance is a vital but sometimes overlooked part of an estate plan. Learn more about estate planning in Texas and Florida from an experienced estate planning attorney at Fleurinord Law, PLLC. Call 888-904-2297 for more information.
Types of Life Insurance
In general, there are two basic types of life insurance. Both options ultimately have the same goal—to provide money for loved ones after someone passes away. However, they are set up very differently, and the two options often have a significant cost difference between them.
Term Life Insurance
Term life insurance can be the most cost-effective life insurance option. This type of life insurance is only effective for a specific amount of time. Most policies are between five and 20 years, but they can be shorter or longer as well. The policy provides coverage only for that specific period of time. Some policies have auto-renew terms, but many require applying for new coverage once the term expires.
In a term policy, someone pays for coverage, and if the covered person passes away during that time, then the insurance company will pay out the coverage amount. If that person does not pass away during the period, then there are no further benefits. There is no cash value of the policy, and there are no premium refunds.
Whole Life Insurance
Whole life insurance is the more expensive of the two options because it is not limited by a specific term—it covers someone for their whole life. In addition, the policy also builds up a cash value. The person who holds the policy can borrow against those funds or even withdraw them. After the insured person passes away, the cash value does not get turned over to loved ones, however. Instead, the insurance company takes the cash value and pays out the coverage amount of the policy.
Policies in this category can be 3 to 10 times more expensive than a term life insurance policy. They provide a low rate of return as an investment vehicle, but they can be very helpful for individuals who are not sure if they can get life insurance coverage after term coverage expires. For instance, they might have a chronic illness or injuries after a life-threatening accident and would not qualify to renew a term policy.
How Are Life Insurance Payouts Paid?
A life insurance payout will often vary based on the type of insurance policy in place. For instance, while most life insurance policies provide only death benefits, some policies can also pay for disability claims or annuity benefits. In fact, the Insurance Information Institute reports that in 2021, surrender benefits with withdrawals for life contracts made up the majority of life insurance payouts. In general, however, when most people want more information about life insurance payouts, they are specifically asking about payouts for death benefits, so these are addressed below. You may want to speak with the team at Fleurinord Law, PLLC to review the full range of payout options available with a life insurance particular policy.
Lump Sum Payout Options
A lump sum payout is exactly what it sounds like—the life insurance beneficiary receives a single check for the full amount of the insurance benefits. This is the simplest payout option. A lump sum payout provides money immediately and allows loved ones to use that money as they wish, whether it is to pay for income replacement or invest the money for the future.
Installment Payment Plans (Annuities)
Many insurance policies will offer an installment payment plan for life insurance benefits. This payment plan will usually involve a regular payment that is provided over a set schedule, such as monthly, quarterly, or annually. The funds will earn a small amount of interest while they sit waiting to be paid out.
Those payments will continue to be made until the full value of the benefits is paid out. If the beneficiary passes away before the payments are all made, then the payments will continue to any secondary beneficiary that is named. If there is no secondary beneficiary or that person has already passed away, then the insurance company keeps the remaining funds.
Whole-Life Payout Plans
In some cases, the insurance company will offer an alternative payment plan method that provides payment for the rest of your life instead of based on the value of the coverage. In that situation, the insurance company is essentially betting that someone passes away before they receive the full value of the coverage benefits. If there are any funds left when the insured passes away, the insurance company keeps those funds.
Interest-Only Payment Plans
Some insurance companies will also offer an option where they invest the insurance proceeds on your behalf and then only pay you the interest from those investments. The beneficiary has very little control over how the investments are made, but they still receive a steady stream of income over time.
Retained Asset Account
Some insurance policies offer a retained asset account, which essentially functions like a checking account with a certain sum in it. The beneficiary can withdraw funds as necessary, and the remaining funds remain in the account. The insurance company will pay a relatively low amount of interest while the funds sit in the account.
Life Insurance Payouts and Taxes
As a general rule, the Internal Revenue Service (IRS) reports that life insurance proceeds received by a beneficiary because of the death of another person are not taxable as income. Taxpayers therefore do not typically have to report insurance proceeds on their income tax return. However, interest received from an insurance policy is taxed as income.
What Is the Best Way To Receive a Life Insurance Payout?
In general, because life insurance proceeds are not taxed for most beneficiaries, it is often a good idea to take a lump sum payment option. Beneficiaries get access to the funds immediately so they can do whatever they wish with that money. If the beneficiary wants to earn interest on the funds, they can invest that money themselves or with an experienced investment professional. Investing that is separate from the insurance company will often lead to a higher interest rate over time, which means your money works harder for you.
Get Help With Estate Planning and Understanding Life Insurance Payouts
If you or a loved one needs help with understanding life insurance payout options and creating an estate plan that works for your family’s needs, consider contacting the experienced and compassionate estate planning team at Fleurinord Law Firm, PLLC. Call 888-904-2297 to learn more and schedule your private consultation.