A settlement is the way in which your life insurance policy proceeds are paid out.
There are many life insurance settlement options that can be confusing at first; your policy may pay out a lump-sum cash payment, life income, a fixed amount, or interest paid periodically.
As a policyholder, you can usually choose the settlement method you prefer although your beneficiary may also get to choose.
Most beneficiaries choose a lump sum payout but it’s a good idea to explore other options. Many life insurance companies offer a guaranteed interest rate on all settlement options with the exception of a lump sum.
Lump Sum Option
The lump sum option is by far the most common of all life insurance settlement options and the most simple to understand. With a lump sum payment, the beneficiary receives the full death benefit all at once and income tax-free. The beneficiary can choose what he or she wants to do with the payout, including investing the money. If the insured had a loan against the cash value of the policy, the amount owed will be subtracted from the death benefit.
If the policy has a $100,000 death benefit, the beneficiary will receive a $100,000 lump sum payout.
Interest Income Option
With this settlement option, the beneficiary can choose to receive only the interest earned on the policy’s death benefit. These interest-only payments are made to the beneficiary while the policy’s original death benefit is paid to a secondary beneficiary when the first beneficiary dies — or when the beneficiary reaches a specific age.
If the policy has a $100,000 death benefit, the beneficiary will receive $5,000 per year (assuming a 5% interest rate). When the beneficiary dies, the secondary beneficiary receives $100,000.
Life Income Option
The life income option means the beneficiary will receive payments for his or her entire lifetime. If the beneficiary chooses this settlement option, the insurance company will decide how much income the beneficiary will receive each year based on age and gender although the company may purchase an annuity instead.
Payouts stop when the beneficiary dies. If the beneficiary dies sooner than expected, the insurance company can keep the unpaid amount in most cases. This option tends to work best for people who want guaranteed payments for life but do not need a large sum of money at once.
To understand how the straight life income option works, imagine a policy with a $100,000 death benefit. A 55-year-old male beneficiary chooses the life income option and receives $6,250 for life, based on his age and gender.
This is one of the more confusing life insurance settlement options because there are four types of options to choose from. Along with the straight life income option explained above, there are three other options.
This type of annuity gives the beneficiary fixed, periodic payments for a certain amount of time, such as 10 or 20 years. The payments will be guaranteed for the full term. If the beneficiary dies before the end of the term, a designated secondary beneficiary will receive the remaining payments.
With a straight life income option, a 55-year-old male beneficiary would receive $6,250 per year. If the beneficiary dies after just five years, he would have received just $31,250 of the $100,000 death benefit. The periodic certain option allows the beneficiary to receive guaranteed payments for life — or for a specific term, whichever is longer. The longer the period chosen, the lower the payment.
If a 55-year-old male beneficiary chooses the periodic certain settlement option with a 20-year period, he receives $4,620 per year for life or 20 years, whichever is longer. If the beneficiary dies after five years ($23,100), a secondary beneficiary receives $4,620 for another 15 years.
Life refund annuities may have fixed, periodic payments until the amount paid out is equal to the amount the beneficiary would have received with a lump sum settlement option.
Joint and Survivor
Joint and survivor annuities provide fixed, periodic payments for as long as either of two beneficiaries is alive with payment ending when the surviving beneficiary dies.
If a policy has a $100,000 death benefit, the beneficiary can choose the joint and survivor life income option for her life and her spouse’s life. The couple will receive $5,600 per year until both die. If one spouse dies, the remaining spouse will still receive the $5,600 per year for life.
Specific Income Option
The specific life option allows the beneficiary to give the insurance company a payout schedule to follow. If the beneficiary dies before the period is over, a secondary beneficiary will receive the rest of the payments.
With a $100,000 death benefit, the beneficiary can choose to receive $10,000 per year (or another amount). The beneficiary receives payments until the benefit is used; in this case, that would be more than 10 years as the insurance company will also pay interest on money not paid out.
Fixed Period Option
With a fixed period settlement, your beneficiary receives payments in equal amounts over a specific period of time. If the beneficiary dies before the time period is over, the remaining balance will pass to a secondary beneficiary.
Good for: This settlement option is good for beneficiaries who need larger payments over a shorter amount of time.
Fixed Amount Option
The fixed amount option, also known as the installment amount option, means your beneficiary will be paid a fixed amount for as long as the settlement proceeds last. Any remaining balance can be passed to a secondary beneficiary if the beneficiary dies before receiving all proceeds.
Good for: This option is good for beneficiaries who need to supplement their income.
Understanding Tax Consequences
While lump sum life insurance proceeds are usually income tax-free for the beneficiary, it’s important to note the exceptions. If the policy was purchased by an employee benefit trust or qualified retirement plan, proceeds are usually taxed as income to the beneficiary. Life insurance proceeds can also be taxed if the proceeds are considered compensation or dividends because a company paid premiums.
Payments received under an installment option are subject to income tax, however. It’s the interest on the payouts (not the principal) that is taxed as soon as it is credited to the beneficiary.
The Bottom Line
While you may not want to consider life insurance settlement options when buying insurance, it’s important to understand the options your loved ones will have so you can better plan for their future. Make sure your beneficiaries understand the options available to them, as they will likely be dealing with grief on top of financial insecurity if the time comes for them to receive a death benefit. The settlement option your beneficiary chooses can mean the difference between a lifetime of security and squandering the money on short-term luxuries.
If you have any questions about these options or anything else related to your life insurance needs, we are happy to try and help you.