A life insurance policy’s settlement option instructs the life insurance company on how to pay the death benefit at policy claim time. Traditionally, the policy owner selects the settlement option, but the beneficiary can change it at the time of the claim. In some unusual cases, the policy owner’s settlement option is irrevocable, and the beneficiary must receive the death benefit according to the payment schedule chosen by the policy owner.
The Four Most Common Settlement Alternatives
The four most common types of settlement are as follows:
- Specified Years
- Specific Amount
- Interest Only
The lump payment settlement option is by far the most popular, and it is typically the default settlement choice. The life insurer pays the beneficiary the policy’s complete death benefit in a lump sum under this option. The beneficiary of the life insurance policy will receive the entire death benefit payment as a single payment (lump sum payment) and will have no further contact with the life insurance company regarding the death benefit payment.
The death benefit of a life insurance policy can be paid to the beneficiary over a defined period of years by the policy owner. The policy owner chooses several years for the life insurer to pay out the death benefit to the beneficiary under this settlement option. Assume the policy owner desired that the beneficiary receive the death benefit over ten years. When the insured dies, the life insurance company will begin making payments to the beneficiary from the death benefit over 10 years.
Because life insurers are required to pay interest on death benefit funds that are not paid to a beneficiary within 30 days of the insured’s death, this settlement option will result in interest earnings on the remaining death benefit held by the insurance company while the death benefit is paid out.
Instead of specifying the number of years, a policyholder could specify a dollar amount that the insurance company will pay to the recipient each year. The insurer will begin paying the recipient this sum annually (or, in some situations, in monthly installments if the insurer allows it) until the total death benefit amount reaches zero. Because the insurer pays interest on any death benefit sum held for more than 30 days, this settlement choice will result in interest being earned on the death benefit total that remains with the insurance company.
A significantly less usual settlement alternative is for the insurance company to make an interest-only payment to the beneficiary. The beneficiary will get a payout of the interest generated on the death benefit sum under this choice; the death benefit will stay with the insurance company. Typically, the insurer will not keep the entire death benefit in perpetuity, but will instead make interest-only payments to the beneficiary for a set length of time before paying the death benefit sum to the recipient. You should be aware that this is not the same as a Retained Asset Account, which is accessible with any death benefit payout option.
What Is the Settlement Option’s Purpose?
A settlement option is typically used to provide the policy owner some discretion over how the death benefit of his or her policy is allocated to his or her beneficiary. In many circumstances, the settlement option may become a spendthrift-like mechanism that limits the amount of money that a beneficiary has at any given time, although it is a relatively ineffective tool for doing so. This may come into play if either the policy owner or the recipient is concerned about the beneficiary’s ability to manage the death benefit monies. It may also help to avoid the stressful considerations that a recipient may have to make when determining what to do with a significant quantity of money.
Consequences of Taxation
Beneficiaries generally get the death benefit of a life insurance policy tax-free. However, interest paid by an insurance company on a death benefit is taxed to the beneficiary as regular income. So, while the total death benefit amount is tax-free, any interest made on it is. This means that whenever a settlement option results in interest payments to a beneficiary, the interest earned is reportable income given to the beneficiary by the insurance company.
The most common approach for a beneficiary to earn interest on the death benefit in the case of a lump sum settlement option is a processing delay. If the insurance company does not pay the entire death benefit to the beneficiary within a certain time frame (typically 30 days), the beneficiary is entitled to interest on the death payment. Furthermore, if the beneficiary does not register the claim promptly after the insured’s death, the life insurance will owe the beneficiary interest for the time that elapsed between the insured’s death and when the beneficiary filed the claim.
Assume Sue did not file the claims on her husband Ned’s life insurance policy until one year after he died. In this situation, Sue will be owed interest on the death benefit for the year that the insurer held her money. It’s unusual for people to fail to file a death benefits claim, but it’s not unheard of.
In the case of a predetermined number of years settlement option, the insurer owes the beneficiary interest on the remaining death benefit that he or she does not get throughout the year. This interest normally adds to the amount of money held by the insurer awaiting payment to the beneficiary, but the interest profits are taxable to the recipient in the year received.
Similarly, if a specified amount option is selected, the insurer will be required to pay interest on the amount left at the insurance firm. This interest payment normally adds to the amount kept by the insurance company, but it is taxable income to the beneficiary in the year it occurs.
Because it is fully interest profits paid on the death benefit that remains at the life insurance company, the whole payment given to the beneficiary is taxable as ordinary income in the case of an interest alone settlement option.
How Does The Option Work?
The policy owner can select a life insurance settlement choice at policy issue or at any time during the policy’s life while the insured is still alive. The insurance owner usually can change the selected option anytime he or she sees it appropriate. If the policy owner does not select a specific settlement option, the lump sum option is usually the default.
The beneficiary will make a claim with the insurance company upon the death of the insured. The insurer will tell the beneficiary of the settlement option at this point. In most circumstances, the beneficiary can accept the option chosen by the insurance owner or alter it to one that better suits his or her needs. It’s also common for the beneficiary to be able to switch from the given number of years, specified payment, or interest-only payment to a lump sum payment at some time in the future. In this situation, the beneficiary is merely instructing the insurer to collect whatever amount remains and distribute it to him/her.
Assume Vince’s father chose the given number of years settlement option, which spreads the payment of the death benefit over 15 years. Vince received payments for five years before deciding that he no longer wants to collect the death benefit systematically. Vince contacts the insurer and wants the remaining funds. The insurer will stop paying Vince and merely pay him the remaining cash held by the insurance firm.
Settlement Options’ Strengths and Weaknesses
Settlement options might address common financial concerns that a beneficiary or policy owner may have about dealing with a big payout from a life insurance policy. However, the procedures used by settlement choices to limit the amount of money a beneficiary will receive at one time are largely discretionary on the recipient’s part.
This means that if the policy owner is concerned about the beneficiary’s ability or willingness to accept the limited payout from some settlement choices, the policy owner may seek greater legal barriers to the money, such as a trust that receives the death benefit proceeds. The settlement option is not intended to be a replacement for more sophisticated legal and/or financial preparation that aims to shield beneficiaries from things like unhealthy financial habits or unscrupulous financial advice.
Instead, settlement choices are best viewed as useful tools for organizing fund distributions in a way that is more in line with how the bulk of Americans handle their financial affairs.