Life Insurance 101: Settlement Options
[This is part 8 of a 9-part series. For a full overview of topics, see the Life Insurance Basics page.]
One of the primary purposes for life insurance is to provide a secure stream of income for survivors. In many cases, this income may need to last a lifetime. While many beneficiaries take the full amount of the death benefit as a lump sum, insurance companies offer an array of Settlement Options that can help meet a family?s financial needs. The following are the most common options available:
- Lump Sum. The beneficiary takes the full amount of the death benefit as a single settlement. The money is received free of income tax. If a stream of income is desired, the beneficiary must purchase an annuity on their own. Beneficiaries would be wise to explore the other options below to see if the insurer can offer a better value.
- Interest Only. The beneficiary leaves the death benefit on deposit with the insurer and receives interest payments. Quarterly payments are normal. The payments are taxed as ordinary income. This option is the most flexible since withdrawals can be
made at any time and all of the other settlement options remain available. Insurers typically offer very competitive interest rates. Many counselors recommend not making any major financial decisions for about a year after the death of a loved one so this option may often be the best to start with.
- Fixed Period. The beneficiary receives income for a specified number of years. Each payment includes both part of the death benefit and some interest, so a portion of the payment is subject to income tax. If the beneficiary dies before all the money is received, the remainder will be paid to their designated beneficiary.
- Life Annuity. This option provides the beneficiary with guaranteed income for the rest of their life no matter how long they live. As above, a portion of each payment is taxable. The payment is determined by the beneficiary?s age and life expectancy. It provides the largest monthly payout and could result in a payout significantly greater than the original death benefit. However, if the beneficiary dies, the income stops and the insurer retains any amount of the death benefit that has not been paid out. Life settlements should therefore be approached with caution.
- Life Annuity with Period Certain. This option provides guaranteed income for the life of the beneficiary with a guaranteed payout for a specified period even if the beneficiary dies early. For example, a Life Annuity with a 10 Year Period Certain would provide income for the life and if the beneficiary died at the five-year point, their designated beneficiary would receive the payments for another five years. Periods of five, 10, 15, and 20 years are common. The longer the period certain chosen, the lower the monthly payment will be. A portion of each payment is taxable.
Settlement Options are often the last thing a person thinks about when buying life insurance. Many people take the attitude that they will be dead so why should they care about it. Understanding and properly selecting settlement options needs to be an important part of life insurance planning. When shopping for life insurance, it is important to ask the insurer what options they make available. Also ask about their record on interest rates. Most importantly, make sure your family understands the options available and discuss which ones would best meet their needs. While the beneficiary usually chooses the settlement option upon the death of the insured, most insurers allow the owner of a life insurance policy to select a settlement option ahead of time. Why would you want to do this? One reason would be to ensure the death benefit provides secure income for your family rather than potentially being wasted or misused. This might be especially important if the beneficiary was not financially competent or was a spendthrift. Note, that the settlement options are also available when surrendering a permanent policy for its cash value. Here, the settlement options offer a way to spread the tax burden of a large gain over several years.
Life insurance is purchased to provide financial security for your family if you are not around to provide that for them. Picking the wrong settlement option can significantly reduce the benefit of a policy. It can mean the difference between a lifetime of secure income or money squandered on a few luxuries. Do not neglect this important aspect of life insurance planning.
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