The policy owner (often the insured person) pays an ongoing premium to the life insurance company (let’s say around $20 per month). If that insured person passes away during a coverage period (10 to 30 years), their beneficiary (usually their family) receives a lump-sum payout.
Think of it as protection for your family against a loss of income, so they can continue to live their life with financial security.
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Often times, the policy beneficiary (recipient of the payout) is your spouse, parents, children or business partner.
If you want your children to be the legal beneficiary and receive the payout, note that a minor cannot receive a life insurance payout until they are 18 years old — until then, the insurance company can hold on to the money. When this is the case, it’s a good idea to set up a life insurance trust that disperses the life insurance money at certain times, or specifies that it can only be used for certain purposes when designating a minor as a beneficiary.
How payouts work
When an insured person dies, it’s the responsibility of the beneficiary named on the policy to file a death claim with the life insurance company in order to receive the payout. After receiving the death certificate, they must send a certified copy to the insurance company.
The beneficiary may need immediate cash, especially if the person who died was a wage earner with dependents. Most death claims are paid in a couple weeks.
Beneficiaries can choose to take payments spread out over time instead of a lump sum payment. In this case, the life insurance company will pay interest on the balance. There are also interest charges payable to the beneficiaries of the life insurance policy for a delay in claims payment.
Taxes and life insurance
The premiums you pay for life insurance aren’t usually tax deductible, but the payout generally isn’t taxable, either.
Beneficiaries don’t have to claim life insurance payouts as gross income on their taxes. If they choose to take payments from the life insurance company over time, they may have to pay taxes on the interest that accumulates in the account.
In some cases, an estate may be large enough to trigger income taxes. If the life insurance policy becomes part of this type of estate, it may be taxable, as well.
A financial advisor can help manage this situation to reduce the potential negative impact on beneficiaries by transferring the policy to an irrevocable trust. This process must be completed at least three years prior to the death of the policy owner.
When making decisions about which type of life insurance to buy, how much to buy, how to handle a payout, paying taxes on life insurance money, or how to manage an estate, it’s a good idea to seek the advice of a tax professional and financial advisor.