This final section of our three life insurance sections discusses additional considerations for life insurance: the tax treatment of proceeds, the information your contract will contain, the designation of beneficiaries and the payment of death benefits. (For more insight, read Life Insurance Clauses Determine Your Coverage.)
The death benefit that a beneficiary receives from a life insurance policy is usually not taxable, as the IRS describes in Publication 525, Taxable and Nontaxable Income. If you were to purchase someone else’s life insurance policy and receive the proceeds when they died – an arrangement called a life settlement or viatical settlement – that income would be taxable. (Learn how this works in Profit from Unwanted Life Policies with Life Settlement.)
Another exception would occur if your beneficiary received the proceeds as a series of annual payments instead of as a lump sum. The annual payments would not be taxable, but if the insurance company paid interest on those payments, then the interest would be taxable. (More on receiving life insurance benefits as a series of payments in a moment.)
Also, if the deceased has an estate that is larger than the federal or state estate tax exemption level, the life insurance beneficiary would pay tax on the value of the life insurance that exceeded the value of the estate exemption. Estate planning strategies exist to avoid this problem. (For related reading, see How Are Life Insurance Proceeds Taxed? and Life Insurance Distributions And Benefits.)
Standard Provisions (sources: http://www.pacificlife.com/content/dam/paclife_corp/crp/public/life_insurance/sample_policies/Sample%20Policy%20P12PPC%20DC.pdf and http://www.rbcinsurance.com/samplepolicy/pdf/your-term-sample-policy.pdf)
Read your life insurance policy contract when you first receive it to make sure you understand how the policy works. Regardless of the type of policy, any life insurance contract will have a summary page with the specifics of your policy, such as how much the death benefit is for and what riders you may have purchased, followed by a standard contract that lays out when your insurance begins, renews and ends; when the death benefit will and will not be paid out and when it may be adjusted; when premiums are due and what happens if you don’t pay your premiums; what options your policy has, such as conversion privileges; and information about naming your beneficiary and transferring your policy. There will be a section defining all the terms used in the policy, such as “face amount” and “insured,” Life insurance with a cash value component will also describe how policy loans work and how they affect the death benefit, how the policy’s surrender value is calculated, and what the policy’s tax qualifications are.
Your beneficiary designations determine who will receive your policy’s death benefit if you die while the policy is in force. You should choose both primary and contingent beneficiaries to ensure that someone receives the benefit you have paid for even if the original intended recipient predeceases you. For example, you might designate your spouse as the primary beneficiary and your siblings as contingent beneficiaries.
If your policy will have more than one beneficiary, you will need to specify how the death benefit should be divided among them. Choosing a “per capita” distribution means that each beneficiary will receive an equal amount of the death benefit, while choosing a "per stirpes" distribution means that if one of your direct beneficiaries predeceases you, the living family member who is most closely related to you will receive that person’s share.
With an irrevocable beneficiary designation, you can’t change the beneficiary without that person’s permission. Life insurance with irrevocable beneficiaries is sometimes used in divorce settlements to ensure that financial obligations to an ex-spouse can be met no matter what, such as providing for the kids’ college expenses. Revocable beneficiary designations are more common and allow you to change your policy’s beneficiary whenever you please by completing the appropriate paperwork.
Death benefits can be paid as a lump sum distribution or via installment option. With a lump sum distribution, the beneficiary receives the policy’s entire death benefit at once, which can be helpful for paying final expenses and managing other post-death costs such as debts that need to be repaid. This option can provide peace of mind and it makes sense if the beneficiaries have the discipline to use the proceeds judiciously.
With an installment option, the beneficiary receives regular payments of the death benefit over time until the death benefit is depleted. It can be a good choice for beneficiaries who might not use the proceeds the way you intended if they receive them all at once. Another situation where an installment option might make sense is if your children are the beneficiaries and you don’t want them to potentially receive a $500,000 windfall at age 25 that might disincentivize them from pursuing their careers.
If you want, you can choose how the beneficiary will receive the proceeds. Otherwise, the choice will be up to the beneficiary based on what the insurance company offers. Here are the most common options:
Straight Life Income Option: One beneficiary receives regular payments from the policy’s death benefit, but payments end when the beneficiary dies and they do not transfer to anyone else.
Joint Life Income Option: Two beneficiaries receive regular payments from the policy’s death benefit, but payments end when the beneficiaries die and the payments do not transfer to anyone else.
Fixed Period Option: The insurer will pay the proceeds to your beneficiary over a fixed period of time, such as 10 years. Payments can be made monthly or annually. A death benefit of $250,000 could be paid out as $25,000 a year for 10 years, for example. The fixed period option can be a good way to provide income for a surviving spouse in the same way it would been provided if you were still alive.
Fixed Amount Option: The insurer will pay a certain amount that you specify to your beneficiaries each month or year. The amount doesn’t have to be the same with each payment. Payments will continue until the death benefit is used up.
Interest Income Option: The policy’s death benefit amount remains with the insurance company, and beneficiaries receive regular payments of the interest income that the death benefit generates. At the end of a number of years of your choosing, the beneficiaries receive the death benefit as a lump sum.
Life Income with Period Certain: If the beneficiary who is receiving monthly or annual income from your policy dies before the death benefit is exhausted, a secondary beneficiary will receive the remaining payments until the death benefit is used up.
Life Income with Refund: If the beneficiary who is receiving monthly or annual income from your policy dies before the death benefit is exhausted, a secondary beneficiary will receive the remaining death benefit as a lump sum.
(For more, see Life Insurance Policies: How Payouts Work.)
Up next is the final chapter of this tutorial, where we’ll discuss other types of insurance that we haven’t covered yet, such as insurance for particular diseases, identity theft insurance and accident insurance.
Intro To Insurance: Other Insurance Policies
Financial AdvisorBeneficiary designations are a critical financial planning step that can be easily overlooked. Here's how to ensure they are properly done.
Financial AdvisorFind out how to make the tough decisions when it comes to choosing who will receive your assets and how they will be paid out.
RetirementA beneficiary is a person or entity that receives funds, assets, property or other benefits from a trust, will, or life insurance policy.
InsuranceDon't make the mistake of naming your minor child as your life insurance beneficiary.
Financial AdvisorLife insurance policies need to be reviewed regularly to make sure that the beneficiary you chose some time ago is still the right choice today.
InsuranceHow to file for a life insurance payout – and how long it takes to receive it. Plus, new ways to plan for payments that provide an income stream.
InsuranceThere are many benefits to owning a life insurance policy - if you get the right one for you.
InsuranceLife insurance provides peace of mind to policyholders and their loved ones.
RetirementLife changes make it time to rewrite your plan's designations.