How does a life insurance policy payout work?

Peace of mind is perhaps the most important intangible benefit associated with purchasing a life insurance policy. It gives you the reassurance that you’re leaving behind financial protection for your loved ones. The beneficiary (or beneficiaries) can use the policy’s death benefit to help cover funeral expenses, meet day-to-day living expenses or plan for the future.

Understanding how a life insurance policy payout works is critical to making sure that you have enough coverage to meet your loved one’s financial needs. But it’s also important for the policy’s beneficiary to consider how life insurance proceeds will be used, should the need arise.

Because the payout of a life insurance policy comes upon the death of the insured, the death benefit can be a sticky subject to address if you’re a beneficiary. Here we’ll talk about how a life insurance policy payout works after the policy owner dies, how it may be used, and how discussing the potential uses of a policy payout now can make certain decisions that come later easier to handle.

Understand your beneficiary status

The first thing you need to know discussing a life insurance death benefit is whether you’re the sole beneficiary of a loved one’s policy, or if your loved one listed multiple beneficiaries on the policy.

For example, say your parents have a life insurance policy and you’re one of five siblings. Each of you could be listed as equal beneficiaries on the policy, sharing equally in the death benefit. Or, your parents may have chosen one of you to be the primary beneficiary, perhaps assigning that person responsibility for dividing life insurance proceeds among the siblings.

You may have a similar situation if you’re married and have young children. Your spouse may name you their primary beneficiary (and vice versa), while also naming another relative or family friend to act a contingent beneficiary in case something happens to you.

Understanding the beneficiary designation on the policy can help minimize confusion over who can access the death benefit. (There’s a lesson here for you as well if you have a life policy of your own.) Talking over your beneficiary designation can help your loved ones be on the same page, minimizing surprises at an already stressful time if you were to pass away.

If you’re a beneficiary for a loved one, know the policy information and how to access key financial accounts. Let your own beneficiaries know they’re named, whether they’re primary or secondary beneficiaries and make sure their identifying info is up to date on your policy.

Be clear about the death benefit amount

While talking about money can be difficult when it involves the death of a loved one, it’s important to understand the policy’s death benefit.

Why? Because as the beneficiary, you have to determine the best use for life insurance proceeds. The first thing you may need to pay for, for instance, are funeral and burial expenses for your loved one. The average funeral costs more than $7,300, and life insurance benefits can help pay some or all of those expenses.

You may wish to tactfully ask the insured person how much coverage they’ve purchased. If it’s someone you’re close to, such as a parent or spouse, this could also be a good time to discuss their wishes with regard to funeral planning or any specific ways they’d like their policy’s death benefit to be used.

For instance, if your spouse has named you as beneficiary he or she may want you to use the money to pay off the mortgage or set cash aside for your children’s college education. Or if a parent has named you, he or she may ask that you use some of the policy proceeds toward any lingering debts or estate taxes. Knowing the amount of the death benefit can help you decide on the best and most feasible uses for the money.

Also, ask the policy owner whether any riders are associated with their coverage that could potentially reduce the death benefit. For example, the policy may include living benefits or an accelerated benefits rider, which would allow a policyholder with a terminal illness to access a portion of the death benefits while still living. The accessible amount is usually limited to a percentage of the total death benefit, and accessing it reduces the amount of money that the beneficiaries will later receive.

If the policy includes a living benefits rider or something similar that would allow the policyholder to tap the death benefit, it’s something you should be prepared for well in advance. In the absence of a rider, the death benefit doesn’t change. It typically doesn’t go up over time even if your loved one has a paid-up insurance policy, and it doesn’t go down even if the policyholder’s life expectancy drops over time because of health issues.

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Know the different payout options

Life insurers can offer you different options for receiving life insurance proceeds after your loved one passes away. For example, you may be offered a lump sum payment, installment payments from an interest-earning account that’s created by the insurance company for you, or an annuity option, which would provide lifetime income.

The payout option is your choice. Many people choose to receive their payment in a lump sum, but if a survivor is overwhelmed or has minimal debts and their immediate bills covered or doesn’t yet wish to make a decision on how to use the money, installment payments or an annuity could make more sense.

One question you might have is whether life insurance proceeds are taxable. Generally, the answer is no, it’s not taxable income. (Although you may have to pay income tax on the interest earned on any money held by the life insurance company.)

Consulting with a financial professional can help give you peace of mind and can help you explore ways you might wish to use the policy payout while minimizing any tax implications.

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Filing a life insurance claim

You may assume that when the insured policy owner passes away, the insurance company will automatically make the death benefit available to you so long as the premium payments have been made. But, there are certain steps you have to take before you can receive life insurance proceeds.

First, you’ll need to get a copy of the insured’s death certificate. If you’re not sure how to do this, you can contact your county or state vital records department to figure out what steps to take. The funeral home you’re working with can also help order this document.

Next, you’ll need to file an insurance claim with the insurance company and submit a copy of the death certificate. Life insurers then review the circumstances of the policy owner’s passing and the details of the policy to determine whether your claim will be approved or denied. For example, if the death occurred within the first two years after the policy’s purchase, the life insurance company could deny the claim if the death was the result of suicide or a pre-existing condition that wasn’t covered by the policy.

The process for completing a life insurance claim can take time — sometimes 30 to 60 days or more. As the beneficiary, you can help things along by having multiple copies of the death certificate available in case they’re needed, and by providing the insurance company with any other supporting documentation that’s required when you file the claim.

Assuming the claim is approved, the next step is payment of the policy’s death benefit. Again, you’ll need to tell the insurance company which payout option you prefer. Once you’ve received the money, you then have to decide how you’ll use it.

Take your time after receiving a life insurance policy payout

Managing a new lump sum of money while dealing with grief can be overwhelming. While everyone’s process is different, experts say you shouldn’t feel rushed to use the money. You may find it helpful to take a few months and live as close to normal as you can — pay bills, go about your routine — before making huge financial decisions like paying off a mortgage.

Also, remember, you don’t have to make these decisions by yourself. Talking to a CERTIFIED FINANCIAL PLANNER® professional or financial professional you trust may help guide you as you tackle big decisions and come up with a plan.

“My family tends to be a do-it-yourself one,” explains Matt Wolf, head of product and analytics at Haven Life. “After my father had passed away, there was an immediate pressure for us, my mother, in particular, to take on all of the things he used to do himself – the taxes, managing retirement assets, and paying the bills. We helped my mother locate a few financial advisors to speak with about her situation. In the end, she decided not to work with any of them on an ongoing basis. However, initial consultations gave her comfort that she was aware of all her options and not missing important decisions.”

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Evaluate all the possibilities for using life insurance money

When you do feel ready to make a financial move with life insurance benefits, people who’ve been through the process say it’s smart to take a big-picture view of all the debts you have now, like credit card balances or a mortgage, and financial obligations expected in the future, like college for your children.

Personal finance common sense says that, generally, it’s smart to handle the higher-interest debts you have first before looking at less costly debt or future obligations. As you consider how to allocate your payout, here are some of the major financial buckets to consider:

High-interest debt

From credit cards to car payments, it’s smart to pay off balances with a high-interest rate quickly. The higher the rate, the more those debts cost you over time.

In addition, it can be helpful to consider how those balances were accrued in the first place and consider ways to budget for the future. A life insurance policy payout can make you feel like you have a long-term financial safety net, but remember that the money is finite, and smart savings and spending strategies can be a helpful tool for any family for the long term.

Housing options

If the policy payout is enough to cover the mortgage, then that’s what you should do, right? Not necessarily. You may also want to consider taxes, maintenance, and general cost of living — how will you pay for those expenses going forward, even after the mortgage has been paid?

Other options, like downsizing to a smaller property or moving to another part of the country where you may have more friends and family, may make sense. Remember that there is no “right” answer. These big questions are where a professional, family and friends, and even time can help. There is no deadline for spending down the death benefit. Consider maintaining the status quo until the next steps are more clear to you.

College and other educational expenses

One of the driving motivations for many people who purchase life insurance policies is to make sure the cost of their children’s education is covered. Assuming the life insurance policy is large enough, and depending on the ages of the children, consider putting money into a college savings plan as it offers the potential to grow over time and can be accessed by children for their education at a later date.

A four-year college degree is expected to cost around $176,000 by 2030. If you know the policyholder wanted to fund his/her child’s college expenses, then that’s a lasting legacy you may wish to honor. Also, money in a 529 plan doesn’t have to be used exclusively for a university education. In 2018, 529 plans were expanded so that they can be used for private K-12 school tuition as well.

You can withdraw up to $10,000 per student per year from a 529 plan to pay for primary or secondary education. This money can only be used for tuition (not school supplies or books). You can also consider a Coverdell account, which offers tax-advantages similar to a 529 plan, but funds can be used for qualified education expenses at an eligible postsecondary school, elementary school, or secondary school.

Investing life insurance proceeds

Another option (and remember, a life insurance policy payout is your money and you have the option to use it for a combination of things) is to invest the money so it has the potential to grow in value.

You can place the funds in an investment account that you already have, or open a new one. Remember, that earnings from investments in a brokerage account are taxable. You’d have to pay capital gains tax when you sell investments at a profit.

Also, bear in mind that investing involves risk, and past performance doesn’t guarantee future results. If the market becomes volatile or your investments don’t perform as well as you expected, you run the risk of losing some or all of the life insurance money you’ve been entrusted with. Again, working with a financial professional can be helpful, and they can also keep you attuned to other ways to grow your cash besides the stock market.

Leaving a legacy

If there are no credit card or other debts to pay and your income covers mortgage payments and other expenses, you may consider using life insurance proceed to create something more permanent. People can advise you, but at the end of the day, it’s your money, it’s your memory, and it’s your life to craft after the death of a loved one.

Some people find that they like to use some of the money from a life insurance payout to memorialize their loved one, in the form of a donation to their alma mater, funding a scholarship, or putting up a memorial bench as a tangible way to leave a legacy. Others like to memorialize their loved one through a family vacation, reunion, or celebration of life.

It’s okay to use some of the money for something fun. Remember, your loved one named you as a beneficiary for a reason. They trusted that you would be able to use the money in a way that could help you maintain quality of life even in the face of loss.

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Give yourself time and space

Grief has no timeline and there is no due date for making your financial decisions.

If you’re on the receiving end of a life insurance payout, you may feel ready to allocate funds right away, or you may take a while. Either is normal. Professional advice can be helpful but isn’t doctrine, and it’s up to you to spend the funds and consider the future in a way you feel most comfortable.

If you’re on the giving end of a term life policy or a permanent life policy, follow up this act of generosity and caring with a conversation about your hopes and intentions. The financial priorities you have today for the insurance coverage you purchase may change over time, so remember to sit down and have the conversation again as those priorities change.

If you’re still navigating the ins and outs to determine how much and what kind of life insurance coverage is best for your family, life insurance quotes are free and easy to get online. A term life policy is a great fit for many people because the cost of term life insurance is very low compared to the cost of permanent life insurance. Many buyers are even eligible for term life coverage with no medical exam. Use a life insurance calculator to see how much coverage might be appropriate for your family.

Have these conversations with your loved ones now. These topics may feel awkward — nothing like talking about “what if I were to die” to spice up a Friday date night, right? — but talking about what-ifs can help you make sure you and your loved one are on the same page. Clear communication can help make the decisions more apparent for a beneficiary if one of you were to die.

A life insurance policy payout can’t bring back a loved one. But it can help you live out the dreams, goals, and wishes you both crafted, and can be a way to truly honor the life someone lived.

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Rebecca Lake is a freelance writer specializing in personal finance and small business. She lives on the North Carolina coast with her two children.

This discussion is intended for general education only and is not legal, tax or investment advice. You should consult your own tax, legal, and investment advisors before engaging in any transaction. Haven Life doesn’t recommend any products or services discussed.

Haven Term is a Term Life Insurance Policy (ICC17DTC) issued by Massachusetts Mutual Life Insurance Company (MassMutual), Springfield, MA 01111 and offered exclusively through Haven Life Insurance Agency, LLC. Policy and rider form numbers and features may vary by state and may not be available in all states. In New York, Haven Term is DTC-NY 1017. Our Agency license number in California is OK71922 and in Arkansas, 100139527.

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