The purpose of life insurance is fairly straightforward: to provide a financial safety net for your loved ones after you die. While it’s important to buy the right amount of coverage, it’s also vital for your beneficiaries to understand the money they are entitled to and how they may want to go about using it. Here’s a closer look at the death benefit.
What Is a Death Benefit?
A death benefit is a payment beneficiaries receive when the life insurance policy owner passes away. When someone buys a life insurance policy, they designate which individuals or entities they want to receive the death benefit upon their passing. Essentially, the death benefit can provides financial support for beneficiaries.
In the event that no beneficiaries are still alive or no beneficiary is named, the death benefit will go to the estate of the policyholder.
Death Benefit vs Face Amount
Typically, when a policyholder passes away, life insurance policies pay a death benefit in 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.
If the policyholder has 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. Understanding the different payment methods will help beneficiaries determine the most suitable option to fit their 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, the gender of the policyholder, and their age 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
Generally, when a policyholder passes away, life insurance companies don’t automatically file claims on the beneficiaries’ behalf. It’s usually the beneficiaries’ responsibility to do so. 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 an 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 the beneficiaries.
• Submit a certified copy of a death certificate from the funeral director along 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 is approved, 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 in order 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.
Recommended: What Are the Different Types of Taxes?
Uses of A Life Insurance Death Benefit
In addition to covering final expenses, life insurance policies can provide a degree of 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 2021 was $7,848. When you factor in the cost of a vault, the median average price goes up to $9,420.
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 on 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 buy 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.
Recommended: How Much Is Life Insurance?
The Takeaway
Purchasing the right amount of life insurance coverage is important, but so is understanding how the death benefit works. The death benefit is money beneficiaries receive when the life insurance policyholder passes away. There may be various different ways to receive the payout, including lump sum payments, income payments, guaranteed payments, guaranteed fixed payments, and interest income payments. If set up correctly, the policyholder can pass the death benefit along to the beneficiaries without incurring any estate taxes on the payment.
If you’re shopping for life insurance, SoFi has partnered with Ladder to offer competitive life insurance policies that are quick to set up and easy to understand. You can apply in just minutes and get an instant decision. As your circumstances change, you can easily change or cancel your policy with no fees and no hassles.
Coverage and pricing is subject to eligibility and underwriting criteria.
Ladder Insurance Services, LLC (CA license # OK22568; AR license # 3000140372) distributes term life insurance products issued by multiple insurers- for further details see ladderlife.com. All insurance products are governed by the terms set forth in the applicable insurance policy. Each insurer has financial responsibility for its own products.
Ladder, SoFi and SoFi Agency are separate, independent entities and are not responsible for the financial condition, business, or legal obligations of the other, Social Finance. Inc. (SoFi) and Social Finance Life Insurance Agency, LLC (SoFi Agency) do not issue, underwrite insurance or pay claims under Ladder Life™ policies. SoFi is compensated by Ladder for each issued term life policy.
SoFi Agency and its affiliates do not guarantee the services of any insurance company.
All services from Ladder Insurance Services, LLC are their own. Once you reach Ladder, SoFi is not involved and has no control over the products or services involved. The Ladder service is limited to documents and does not provide legal advice. Individual circumstances are unique and using documents provided is not a substitute for obtaining legal advice.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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.
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