How Do Life Insurance Payouts Work?

What Is Life Insurance and How Does It Work?

Life insurance provides beneficiaries with financial support upon a policyholder's death. When a person buys life insurance, they pay an annual premium in exchange for a certain amount of coverage.

If a policyholder passes away while the policy is active, beneficiaries receive a death benefit equal to the coverage amount. That money can be used for funeral expenses, paying off debts or medical expenses, and to cover daily living expenses if beneficiaries were dependent on the policyholder's income.

What sets apart life insurance from other types of insurance is that it's possible to accumulate cash value on certain policies. Here are the two main types of life insurance:

• Term life insurance: These policies provide coverage for a set period, typically one to 30 years. Premiums are usually the same for a policy's duration, and the policy pays out a death benefit if the policyholder passes away during the covered term. Term life insurance does not accumulate cash value—a payout only happens when the policyholder dies. That makes it similar to other forms of insurance.
• Whole life insurance: This is the most common form of permanent life insurance, which stays in force as long as the policyholder is alive, assuming premium payments stay current. Cash value on your policy builds up while the policy is in place, and can be borrowed against or withdrawn for personal use. (Withdrawing funds lowers the death benefit, and the policy will be canceled or surrendered if the cash value reaches zero.) Cash value can also be traded in to increase the death benefit amount.

Life Insurance Payout Options

Beneficiaries of life insurance policies must file a claim with the insurer to collect the death benefit. Once a claim is approved, beneficiaries can choose to receive the death benefit in one of the following ways.

Lump Sum

Receiving the entire death benefit in one payment is a common choice. It comes with the advantage that you likely won't pay income taxes on the amount you receive—though a life insurance payout may affect whether and how much in estate taxes must be paid.

Receiving a lump sum can be risky if the funds are not managed properly. Also, if you deposit the funds in your bank, Federal Deposit Insurance Corp. (FDIC) insurance only covers up to $250,000 per depositor, per institution in each ownership category. So it may be necessary to break up a lump-sum death benefit into various bank accounts to get full FDIC coverage.

Installment Payments

You can also receive monthly installments over a set period to ensure the money doesn't run out quickly. For example: If the death benefit is $600,000, you could request $30,000 in payments each year for 20 years. The life insurance company will hold the money in an interest-earning account and you'll owe taxes on the interest earned on the balance.

Retained Asset Account

If your insurance company offers this option, policy proceeds can be placed into an interest-bearing account. That means the death benefit amount will accrue interest, which is taxable. Beneficiaries receive a checkbook if they need to access the cash. Also, the insurance company guarantees the proceeds in the account, even if the balance exceeds the $250,000 limit set by the FDIC.

Annuity

Converting a life insurance payout to an annuity gives beneficiaries guaranteed payments for as long as they're alive. Insurance companies determine the payment amount based on the beneficiaries' ages when they file the claim and the amount of the death benefit. Any portion of the death benefit that remains when the beneficiary dies goes back to the insurance company, unless the beneficiary opts to receive the annuity for a set period only (referred to as a "life annuity with period certain"). In this case, what's left will then go to designated beneficiaries.

Learn more: Annuities vs. Life Insurance: What's the Difference?

How Does the Life Insurance Payout Process Work?

Beneficiaries must file a claim with the insurance company and provide a certified copy of the policyholder's death certificate in order to receive a payout. Here's how the process works for term life insurance policies and whole life insurance policies.

Term Life Insurance Payouts

A term life insurance policy is only active for a set period of time; 30 years, for example. If a policyholder dies while coverage is in place, the beneficiaries receive the death benefit as outlined in the policy. If a term life insurance policy expires, the policyholder no longer pays premiums and no longer has coverage—unless they choose to renew the policy, get a different one or convert term life insurance to permanent life insurance.

Tip: Beneficiaries will not receive a payout if a policyholder previously had a term life policy, let it expire and then did not get new coverage.

Whole Life Insurance Payouts

Like term life insurance policies, whole life insurance policies also pay a death benefit to beneficiaries when you die. Since whole life insurance is a type of permanent life insurance, it lasts the policyholder's entire life as long as they pay the premiums. But there's a big drawback: If there's any cash value associated with the policy when the policyholder dies, the insurance company, not the beneficiary, gets the cash.

How Is Life Insurance Paid Out to Beneficiaries?

Life insurance payouts also vary by the type of beneficiaries that are named on the policy. Here's what you can expect in each scenario:

• One primary beneficiary: The single person or trust named by the policyholder can claim the payout.
• Multiple primary beneficiaries: Each beneficiary must file a separate claim for their portion of the payout. The policyholder will have identified how the payout will be divided, either by percentages or specific amounts of the death benefit.
• Contingent beneficiaries: It may be the case that all the originally named beneficiaries have died. If so, the named contingent beneficiaries will receive the payout, after individually filing claims with the insurance company.
• No beneficiary: If all primary and contingent beneficiaries have died, the policyholder's estate will receive the death benefit. That means it may take time during the probate process before the insured person's heirs receive a payout; the death benefit may also be used to pay off the policyholder's debts first.

How Long Does It Take to Get Life Insurance Money?

Insurance companies usually pay out a death benefit a few days to a few months after receiving a completed claim form and a certified copy of the death certificate. The time frame varies greatly by company and can take longer based on the particulars of the policyholder's situation. There could be delays, for example, if the policy was recently purchased or if the insurance company has reason to believe fraud may have occurred when the policy was issued.

Tips for Choosing Between Payout Options

If you're a beneficiary deciding how to receive a death benefit payout, consider these factors:

• Your current financial needs: Certain payout options, like a lump sum, are better if you need more access to liquidity—for example, if you have high-interest debt to pay off. If, however, you'd rather have a sustained stream of income, installment payments or an annuity could be a better choice.
• Your money management style: It may feel overwhelming to receive a large windfall, especially if it's unexpected. For some, a lump-sum payout could be an invitation to spend in a way they might regret. In that case, installment payments may be a good option to prevent short-sighted spending.
• Your age: Annuities may not be as useful to young beneficiaries as other payout options. An annuity provides fixed payments for life based on the amount of the death benefit, so if you're young, you'll receive less per month over a long period of time. That might not make up for the amount of financial support the policyholder provided each month or meaningfully help you meet your financial goals.
• Taxes: You aren't required to report a death benefit payout as income on your taxes. But any interest you receive on the benefit is taxable income, which may be relevant for you if you choose installment payments or a retained asset account as a payout method.
• Flexibility: Annuities don't offer much flexibility, since they provide fixed payments. With installment payments, it may be possible to increase or decrease the amount you receive each month based on your needs. A lump-sum payment provides the most flexibility, in that you can choose to direct large chunks of the funds in multiple ways—spending it, saving it, investing it, donating it or using it to pay off debt.

Frequently Asked Questions

The Bottom Line

Receiving a life insurance payout can be a major event in your financial life. You can typically choose to accept the death benefit in a lump sum, in installments, in a retained asset account guaranteed by the life insurance company or in an annuity. Choose the option that helps you meet your personal financial goals, both in the immediate aftermath of the payout and for the long term.