Most people don’t think about how life insurance payouts work unless they’re filing a life insurance claim. If you’re in that situation right now, we feel for you. To make this difficult time a little easier, we’ve put together the information below to help you understand how the process works and what your options are if you find yourself the beneficiary of a life insurance policy or need to help someone else make a claim. Here are the steps you will go through in the payout process.
Filing a death claim
The first step is to contact the insurance company with the deceased’s name, date of birth, Social Security number, and policy number. If you don’t know the policy number, the company will have other ways to locate the policy, but knowing the number may speed things up.
If you don’t know which insurance company the deceased held a policy with, you may find the answer in their bank or credit card statements. And if you can’t, don’t worry: the law requires insurers to search the Social Security Administration’s database of death records at least twice a year and locate the beneficiaries of any policy that might exist.
Next, you will receive a claims packet of paperwork to complete by hand or electronically. You’ll also need to provide a legal death certificate.
When are benefits paid?
The loss of a loved one’s income or caretaking work can have an immediate financial impact on families. Life insurance companies understand this and are prepared to act quickly to pay benefits. The sooner you initiate the process, complete the claims packet, and provide the death certificate, the faster your benefits will be paid.
Don’t sacrifice accuracy and completeness for the sake of speed, as mistakes will slow things down. The payment timeline will vary by insurer, by state, by policy, and by the circumstances of the death.
In general, it’s reasonable to expect payment within two to four weeks of starting the process. One major insurer says it provides the claims packet within 3 business days of the initial request, begins reviewing the claims packet within 2 business days of receipt, and processes claims payments within 10 business days of completing its review of the claims packet.
A term policy claim may be completed faster, and a permanent policy claim may take a bit longer since these policies can have cash accounts, policy loans, and investment accounts that must be dealt with in addition to a death benefit.
Possible payout delays
A life insurance company might delay or deny paying a policy’s death benefit under a few circumstances:
- The insured dies during the contestability period. Depending on the insured’s state of residence, this period may be one year or two years. During the contestability period, the insurer may investigate the accuracy of all information on the insured’s policy application. The insurer may deny a claim due to fraud or misrepresentation–for example, if the policyholder failed to disclose a known medical condition or regular participation in a risky hobby.
- The insured commits suicide. During the contestability period, the insurer may deny a claim if the cause of death was suicide.
- The insured died while engaged in illegal activity.
- The insured was murdered. The insurance company will need to verify that the beneficiary did not murder the insured before paying the claim. If charges are filed against the beneficiary, resolution could take several months or even years.
Most life insurance claims don’t fall under these circumstances. And even when these circumstances arise, the insurer may still pay the claim after the investigation. But the time taken by the investigation could delay the beneficiary’s payment by 6 to 12 months.
Who Receives the Life Insurance Payout?
The entity that the insured designates to receive their life insurance policy’s death benefit is called the beneficiary. The beneficiary could be the insured’s estate, a trust, or an individual or individuals.
Types of Beneficiaries
The two types of beneficiaries are primary beneficiaries and contingent beneficiaries. The insurer may require each beneficiary to complete a claim form, though it will only need one death certificate.
The insured’s first choice as to who will receive the policy’s death benefit. A policy can have more than one primary beneficiary. For example, a mother might name all three of her children as primary beneficiaries and designate 33.3% of the proceeds to go to each child.
The insured’s second choice as to who will receive the policy’s death benefit. If one or more of the primary beneficiaries dies before the policyholder does, a contingent beneficiary or beneficiaries will receive all or part of the payout. For example, a wife might name her husband as her policy’s primary beneficiary, and if the couple has no children, she might name her niece as the contingent beneficiary.
Life Insurance Payout Options
When most people think about receiving a life insurance payout, they think about receiving a check for the entire face value of the policy. However, this isn’t the only option.
Most common life insurance payout options
Insurance companies understand that receiving a financial windfall can create unique challenges that many people are not well equipped for. So, you may have at least six options for receiving the payout. Options may vary by insurer.
A lump sum is just what it sounds like, and it’s often the default option. The insurance company will cut you a check or initiate an electronic funds transfer to pay the policy’s death benefit. This may be the only option for a small death benefit or non-U.S. beneficiary.
Receive guaranteed payments for the rest of your life, even if you outlive your projected lifetime. If you die before the policy’s full death benefit is paid out, your beneficiaries will inherit the remaining installment payments.
You will receive regular payments for the rest of your life. The amount of each payment will be based on your estimated life expectancy given your gender and age. If you outlive this age, you will keep getting the same payment. If you die sooner, payments end, and the insurance company keeps any remaining death benefit. This option is similar to an annuity.
One possibility may be to choose a certain number of years over which you’ll receive payments and the frequency with which you’ll be paid. For example, you might decide to be paid monthly for 30 years. If you die before the period certain is up, your estate or beneficiary will receive the remaining payments through the end of the period. A period certain plus life payout will make sure the payments don’t run out before you die.
With this option, the insurance company keeps the payout in an account for the beneficiary, who can make withdrawals from the account but not deposits. The account balance earns interest but is not FDIC insured. Instead, it is backed by the financial strength of the insurance company and the state guaranty fund, but it is also subject to the claims of the insurance company’s creditors.
Some life insurance payouts are so large that just the annual interest they accumulate is a significant sum. If you don’t need a lump sum and would rather preserve it to pass on to someone else one day you might choose to receive only the interest income generated by the death benefit and leave the benefit itself alone.
You can also leave the interest income in the account and let the interest compound. This option does not preclude withdrawing portions of the death benefit as needed, though the insurance company may limit such withdrawals to a few times a year.
Tax Rules for Life Insurance Payouts
In general, life insurance payouts are not taxable. However, all or part of a life insurance payout may be taxable in certain circumstances.
If you choose a payout option other than a lump sum, the insurer will be required to pay interest on the amount of the death benefit it hasn’t paid out to the beneficiaries yet. This interest income will be taxable, similar to the interest you earn on a checking or savings account.
Estate and inheritance taxes
Wealthy individuals sometimes use irrevocable living trusts to avoid taxes on life insurance proceeds and even use life insurance proceeds to pay estate taxes. Most individuals, however, do not owe estate or inheritance taxes because of state and federal tax exemptions.
In 2020, an estate worth less than $11,580,000 is not subject to federal estate tax. Estate tax is based on the total value of the deceased’s cash, securities, real estate, annuities, business interests, lifetime taxable gifts, and certain other assets (which may include insurance payouts). Subtracted from these assets are transfers to a surviving spouse, debts owed, estate administration expenses, and charitable donations. If the estate’s value after these subtractions exceeds the $11,580,000 exemption, then estate tax may be due.
At the state level, some states have no estate tax, some use the federal threshold, and some use a lower or higher threshold.
While the estate tax is technically paid by the deceased party, inheritance taxes are technically paid by beneficiaries. In reality, the tax always comes out of the beneficiary’s pocket. Some states levy an inheritance tax instead of an estate tax. The federal government does not levy an inheritance tax because it levies an estate tax.
A simple process for a difficult time
While completing the paperwork to receive a life insurance payout is usually a simple and straightforward process, deciding how to receive the payout can be more complicated. Consulting with an independent financial professional who is required to act in your best interest may be a good way to get help with this decision.
Don’t be afraid to ask for help or take the time you need. Finally, try to take a bit of comfort in knowing that your loved one has provided you with financial support through their life insurance policy.