Life insurance serves many purposes, from income replacement to financial security in retirement. But estate planning — specifically, the creation of a tax-free inheritance for loved ones — is life insurance’s most recognized and popular feature. The policy’s death benefit, paid out to your named beneficiary after you pass, makes that possible.
That payout is called the “settlement” of your policy, and it can take different forms. Your beneficiary might receive the death benefit in a single lump-sum, for example, or as a lifetime stream of payments. Normally, you as the policyholder would choose the structure of the life insurance settlement, but your policy may allow your beneficiary to change it later.
Life insurance settlement options are notoriously confusing, particularly when you try to compare them. Evaluating a lump-sum payment relative to an annuity, for example, can feel like an “apples-to-oranges” comparison unless you are a trained statistician. Thankfully, you don’t need a knack for number-crunching to identify which settlement option best suits your situation. All you have to do is review this in-depth guide we created to help folks like you make an informed choice about life insurance settlement.
Read on for an overview of the six most common life insurance payout options. By the end, you’ll have working knowledge of lump-sum payments, interest income payments, interest accumulation, fixed period and fixed amount payout, and the life-only settlement, also known as the life annuity.
1. Lump-sum payment
Lump-sum payment is the simplest and most common insurance type of life insurance settlement. Once the insurance company receives and validates the life insurance claim, your beneficiary will be paid the death benefit in a single, tax-free payment. As with all life insurance settlements, there are no restrictions on how the money is used. The beneficiary could pay off debt, invest, or spend the entire death benefit on boats and cars.
Note that if the money is invested in some way, any earnings from that investment would be considered taxable income.
As you might guess, lump-sum payments are best suited for beneficiaries you trust to be responsible. If you are concerned your beneficiary might spend the funds too quickly, look to a different type of settlement that would provide a series of smaller payments instead.
2. Interest only
With an interest-only settlement, the insurance company holds the principal of the death benefit and pays any earnings on that amount to the beneficiary. You can think of this settlement format as a savings account you fund for your loved one. Your beneficiary will receive regular interest payments and may be able to take larger withdrawals from the principal upon request. But no large cash payment is made up front, so you can worry less about your beneficiary spending the money all at once. The purpose of an interest-only settlement is to provide a consistent income stream to support the beneficiary’s lifestyle while leaving the principal sum alone so it can continue growing and serve as an emergency fund if the need arises. This payout option is appropriate when the beneficiary is either very young or financially inexperienced.
You should ask your insurance company to explain how the death benefit will be invested after you are gone. If you can estimate the growth rate, you can then project the size of the interest payments that your beneficiary would receive.
3. Interest accumulation
An interest accumulation settlement is not really a payout at all. In this case, the insurance company hold the funds indefinitely on behalf of the beneficiary. The interest earned is added to the account balance. If the beneficiary needs to access the funds, he or she could request a withdrawal. As with an interest-only settlement, it’s wise to confirm that these funds will be invested to earn a competitive growth rate.
You’d select an interest accumulation payout when the beneficiary is financially stable and plans to use the money as an emergency fund.
4. Fixed period
The fixed period settlement option leaves the death benefit and earned interest with the insurer, who distributes equal payments over a specific period of time. That monthly check functions as tax-free income and can help your beneficiary cover living expenses. The purpose of the fixed period settlement option is to ensure your beneficiary receives a consistent stream of income over a set length of time. It’s most appropriate when the beneficiary has a debt like a mortgage that requires consistent payments. Say he or she has 10 years left on a mortgage with $1,5000 monthly payments. A monthly settlement payment of $1,500 plus interest that lasts for 10 years would help your beneficiary reach the point of owning that home free and clear. The option is also suitable if the beneficiary is living in a nursing home or assisted living, as the consistent payments can cover the cost of staying in these communities.
You can also specify a contingent beneficiary, who would continue receiving the payments if the primary beneficiary passes away.
5. Fixed amount
A fixed amount settlement structures the benefit as a fixed monthly payment. That payment will last until the principal and any earned interest are depleted. Your beneficiary may have the option to raise or lower the monthly amount. The fixed-amount settlement does discourage your beneficiary from spending the benefit all at once, but the money can still run out quickly if the payment is too high. You’d select this settlement format if your beneficiary needs temporary help with living expenses — to get through law school, for example.
6. Life income (also known as life-only or life annuity)
The life income settlement format provides a stream of payments that last until the beneficiary passes away. A life annuity provides a reliable source of income, but there are drawbacks. If you request settlement as life-only, your beneficiary may not be able to change to a different settlement format. Extra withdrawals would not normally be allowed, either. It’s also likely you won’t know the payment amount. That’s because the payments would be calculated based on the death benefit and the beneficiary’s age when you pass away. Younger beneficiaries would get a longer stream of smaller payments. Older beneficiaries would get a shorter stream of larger payments. For that reason, life annuity settlements are often more advantageous to older beneficiaries.
To cash out your life insurance while you’re living, consider a life settlement
If none of these options sound right for your situation, you might prefer to liquidate your life insurance while you are living. You can do this through a life settlement, which is the sale of your life insurance to a third-party for cash. The sales price will be higher than the policy’s cash surrender value, but lower than your death benefit. Your age, health, and policy details will determine the exact selling price, but your insurance could be worth 20% to 60% of the death benefit — in cash payable to you.
The proceeds from a life settlement are paid to you directly in one lump-sum payment, and there are no restrictions on how you use the funds. You could set up an investment account with named beneficiaries, for example. You could also pay off debt, earmark the money for your future healthcare expenses, or buy an RV. Be aware, though, that some of your life settlement proceeds may be taxable. Not everyone qualifies for a life settlement, however. For example, life insurance buyers expect selling policyholders to be at least 65 years old. Buyers also prefer policies worth $50,000 or more. And while most types of life insurance are sellable, some are not.
Harbor Life Settlements can review these qualifications with you and also estimate the value of your policy, for free and without obligation. Even if you’re not sure you want to sell, it’s always a good idea to know the value of your assets. Reach out to our team here or by phone at 800-694-0006. We’re happy to help!