The purpose of life insurance is to provide a financial safety net for the insured’s beneficiary or beneficiaries after their passing.
While it’s essential to buy the right amount of coverage, it’s also vital for beneficiaries to understand the death benefits they are entitled to and how they should go about using it.
Related: How much is life insurance?
What is a Death Benefit?
A death benefit is a payment beneficiaries receive when the life insurance policy owner passes away. When consumers buy a life insurance policy, they predetermine the individuals they want to receive the death benefit upon their passing. Essentially, the death benefit provides financial support for dependents who rely on the policyholder’s income.
In the event that no beneficiaries are still alive or a beneficiary was not named, the death benefit will go to the estate of the insured.
Death Benefit Versus Face Amount
Typically, when the policyholder passes away life insurance policies pay a death benefit in the amount of the face amount indicated on the policy. A permanent life insurance policy’s face amount can decrease or increase due to several different circumstances.
For example, the policyholder can decide to pay an additional amount towards the death benefit with dividends or increase the cash value element, such as what is sometimes seen with a universal life insurance policy. On the other hand, the face amount can decrease if the policyholder took out a loan or withdrawal.
Whereas with a term life insurance policy, the face amount and the death benefit remain the same.
Death Benefit Payout Options
Some insurers offer various ways to receive life insurance payouts. As a beneficiary, it’s essential to understand the payout options insurance companies may offer. Understanding the different payment methods will help determine the most suitable option to fit the beneficiaries’ financial needs.
Lump-Sum Payment
Most insurance companies use a lump-sum payment as the default payment option. With a lump-sum payment, the beneficiaries receive the full death benefit at once via a check or electronic transfer.
Income Payments
Beneficiaries can choose an income payment method where they receive payments for a specific amount of time until the death benefit is gone.
Income for a Lifetime
For those who want income for a lifetime, beneficiaries can select guaranteed payments. Essentially, these payments pay beneficiaries a fixed amount in regular intervals based on the total death benefit and the gender and age of the policyholder when they died.
Income for a Specific Amount of Time
The beneficiaries can receive guaranteed fixed payments for a set amount of time, usually between five and 20 years.
Interest Income Payments
Some insurance companies offer beneficiaries the opportunity to put the death benefit in an account that bears interest. They can then receive interest payments periodically and choose to give the death benefit to a secondary beneficiary.
It’s worth mentioning that lump sum payments are typically tax-free. However, if beneficiaries choose to take a payment option, a portion of the payment could be subject to taxation.
Also, beneficiaries who choose the interest-only benefit may have to pay taxes on their regular income. When selecting a payment option, it might be wise to consider consulting with a financial planner to help minimize any tax implications.
Filing a Life Insurance Claim
Even if a policyholder passes away, life insurance companies don’t automatically file claims on the beneficiaries’ behalf. Therefore, it’s the beneficiaries’ responsibility to do so. If the owner of a life insurance policy passes away, here’s how to begin the claim process:
- Gather copies of the death certificate. Beneficiaries must first gather several copies of the death certificate.
- Contact insurance agent. An insurance agent can help beneficiaries identify the steps involved in filing a life insurance claim. They can provide the correct paperwork and act as a liaison between the insurance company and beneficiaries.
- Send in a certified copy of a death certificate from the funeral director with claim forms. In general, it takes two to four weeks to process a death claim. But depending on the specific situation and procedure, it can take longer.
Once the claim receives approval, the beneficiaries can select a payment option and decide how to spend the money.
Is a Life Insurance Death Benefit Taxable?
If set up correctly, death benefits rarely have tax implications. In other words, the policyholder can pass the death benefit along to the beneficiaries without incurring any estate taxes on the payment.
However, to ensure no tax implications, there are a few requirements regarding ownership of a policy that must happen before and after the policyholder passes away.
For instance, a policyholder must name a beneficiary to bypass estate taxes. If a beneficiary was never named, the death benefit may go to the estate and be subject to probate.
It’s also important to note that if a beneficiary receives any interest payment, they are subject to taxation on the interest amount.
Uses of A Life Insurance Death Benefit
In addition to covering final expenses, life insurance policies can provide financial security to the beneficiaries.
Final Expenses
According to the National Funeral Directors Association, the national median cost of a funeral with viewing and burial for the calendar year 2019 was $7,640. When including a vault, the median average price goes up to $9,135.
With the high cost of funerals, some life insurance policyholders may use their life insurance policy to cover final expenses such as funeral costs or medical bills.
Income Replacement or Debt Payment
A death benefit can also be used to replace the income of the insured. Suppose the insured’s beneficiaries rely on their income for financial support. In that case, the death benefit can help pay for expenses they need help with, such as mortgage payments or college tuition costs.
Policyholders may also want to use the death benefit to pay off outstanding debt balances, such as car loans or credit card debt.
An Inheritance to Heirs
A life insurance policy can provide an inheritance to the policy’s beneficiaries for those who don’t have assets to pass to their heirs. Naming an individual a beneficiary to a life insurance policy can help ensure they receive monetary support after the policyholder passes away.
Upon receiving an inheritance, some heirs may have to pay estate taxes depending on the state of residence. If the heirs are receiving a large estate, the estate taxes might be very high when the assets move to the heirs. Even though some assets are not liquid, such as real estate or art, the IRS still requires taxes on these assets. Therefore, heirs may not have the funds readily available to pay the tax bill without selling the assets.
A life insurance policy can ensure the heirs have plenty of money to pay all necessary taxes, so they don’t have to sell treasured family assets.
Minimize the Loss of a Key Leader of an Organization
If a business’s success relies on the role of a critical person, the business may suffer if this person were to pass away. To minimize the financial impact of losing a key person, some companies may purchase life insurance policies to protect their interests.
The policy’s death benefit can help navigate the transition and lessen the financial loss to the company.
This type of insurance is known as key man insurance. It is used to ease the burden of loss to the organization and assist in covering the taxes on the transfer of ownership to the organization’s remaining partners.
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Ladder Life term life insurance policy made available through Ladder Insurance Services, LLC (Ladder) and underwritten by Fidelity Security Life Insurance Company, Kansas City, MO. Product availability and features may vary by state. Not available in New York. The California license number for Ladder is OK22568. Policy Form No. ICC17-1069, M01069, Policy No. TL-146.
Third Party Trademarks: Certified Financial Planner Board of Standards Inc. (CFP Board) owns the certification marks CFP, CERTIFIED FINANCIAL PLANNER, CFP (with plaque design), and CFP (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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