How Life Insurance Payouts Work

Understanding life insurance payouts

How do life insurance payouts work? Also called death benefits, a payout is the amount received by beneficiaries on the death of the insured. It may be the amount agreed on by the policyholder and insurance company when the coverage was purchased—but there are a few reasons why it might not be the same amount. We explore when that might be the case in this guide to life insurance payouts.

One important detail about life insurance payouts is that insurance companies won’t automatically know when a policyholder has passed away. It’s up to the beneficiary to contact the insurer and start the claims process. Once the beneficiary contacts the life insurance company, they will need to provide a death certificate and any other necessary documentation to initiate the payout.

The way the death benefit is distributed depends on how the policy was set up. The policyholder designates one or more beneficiaries, who are the individuals or organizations that will receive the payout. The death benefit is typically paid out as a lump sum, though some policies may offer other options like installment payments or an annuity.

Regardless of the type of life insurance policy — whether it’s term life or permanent life — the key is that the payout process begins when the beneficiary notifies the insurer. The insurer will review the claim, and as long as everything is in order, the payout will be processed, helping provide financial security for the beneficiary.

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.

The death of a loved one is an emotional time. When faced with the task of making a life insurance claim, it’s understandable to feel overwhelmed and unsure of what to do. After all, it’s not a task we do often (hopefully).

A Reddit thread recently highlighted some confusion about the difference between an estate executor and a life insurance beneficiary and when a life insurance claim can be made.

Let’s dig into this Reddit question. Life insurance with a named beneficiary bypasses the probate process, so you do not have to wait to file a life insurance claim.

The beneficiary absolutely can file the claim on their own behalf — and that’s usually what happens, as the insurance company cannot give out private policy information to just anyone who asks about it. However, it is typically permitted for an estate executor or power of attorney agent to start the claims process, but the payout will be paid directly to the beneficiary, not a third party.

By staying informed about your rights, you can navigate the claim process confidently and ensure your loved one’s wishes are fulfilled.

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, such as whole life insurance, is more complex than term, and includes a cash value, an amount that accrues over time in an interest-bearing account. The cash value is tax-deferred, and the policyholder may be able to access it during their lifetime, either borrowing or withdrawing from it. Whatever is taken out of the cash value, however, and not paid back, will decrease the death benefit.

Some permanent policies from mutual insurance companies also offer dividends, which can be taken as cash, used to pay premiums or to purchase paid-up additions (PUAs). PUAs are small amounts of life insurance that increase the value of your policy and its death benefit.

Guaranteed issue policies may feature a graded death benefit period, typically two or three years, which means that if the insured dies during this time, they receive a smaller death benefit or the return of premiums paid and interest, but no death benefit.

Explanation of loans vs. withdrawals

The two ways you can access the cash value in a permanent life insurance policy are via loans and withdrawals. Here’s a comparison of the two:

Riders can impact payouts

Riders are optional add-ons that give further functionality to your policy, which can impact the payout, either increasing or decreasing it. Some riders allow policyholders to use part of the payout under specific conditions, for example.

Common riders include the following:

• Accelerated death benefit: If the insured is diagnosed with a terminal illness, they may access part of the payout to pay medical expenses, thus reducing the amount of death benefit available to beneficiaries.
• Chronic and critical illness riders: As the name suggests, these allow policyholders to access part of the death benefit if they are diagnosed with a chronic or critical illness, such as severe stroke or Alzheimer’s disease.
• Long-term care (LTC) rider: If the policyholder needs funds to pay for long-term care, they can access part of the death benefit. Again, the payout would be reduced by the amount accessed.
• Accidental death rider: Increases the payout if the insured dies in an accident.

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: The entire death benefit is received in a single, usually tax-free, payment.
• Installments: Regular payments are made over time, usually monthly, quarterly or annually, providing a steady income stream. Interest earned can be taxable.
• Retained asset account (RAA): This is an interest-bearing account held by the insurer. The beneficiary accesses it through a checkbook to draw funds as needed. Interest earned on RAA’s may be taxable.
• Interest-only payout: This is when the insurer holds the death benefit and sends regular payments of interest, which may be taxable, to the beneficiary. The principal can be passed on to other beneficiaries.
• Lifetime annuity: An annuity is essentially guaranteed payments for the life of the beneficiary. If the beneficiary dies before the death benefit is exhausted, the remaining amount reverts to the insurer.
• Fixed-period annuity: With this type of annuity, the death benefit is paid out over a specified period. If the beneficiary dies before the period is finished, their beneficiaries receive the remaining amount.  

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

Contact the insurance company as soon as possible after the insured’s death. You will probably need to submit an official death certificate and claim form or other paperwork. Each state has laws on how long the insurer can take to review the claim, often 30-60 days.

Bankrate Personal Finance Writer Lane Gillespie’s mother, Suzanne, shared her experience of filing a claim after her husband passed away: 

From this experience, it’s clear that being proactive can make a difference when filing a claim. If you haven’t received the necessary paperwork after a few days, don’t hesitate to follow up with the insurer. Sometimes, cases may change hands, and it’s important to stay on top of the process to avoid delays. By staying organized and persistent, you can help ensure the claim is processed smoothly and efficiently.

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 $206,000, 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.