Getting life insurance is a no-brainer, as it can provide your family and loved ones with crucial financial protection if you pass away. But how exactly does it work? And by that, we mean how does it “kick in” and provide the benefits once you die? Let’s explore this question and more.
First steps
First, it’s worth mentioning that it is the responsibility of the policy beneficiary, or beneficiaries, to file a claim. In other words, they must contact the insurance company and inform them of the policyholder’s death, typically by sending a death certificate and filling out a claim form to ask the insurer for the money. Contrary to what some may believe, there is no “death list” that goes around to perform this task automatically, so know that it’s not the life insurance company’s responsibility to realize that you have passed away or chase down your beneficiaries.
Because you will likely want to know who gets your money after you die, be sure to create a will that clearly states who will receive your money and informs them that you purchased a life insurance policy. In your will, it’s very helpful to include detailed information, such as your policy number and accurate contact details for your insurer. Without this information, it may take some additional time to verify your claim before the payout is received.
With all information in order, the beneficiary can proceed with contacting the insurer, sending the death certificate, filling out the claim forms and receiving the processed benefit amount when it’s paid out.
More detailed information on the entire claims process can be found here.
Who gets your life insurance payout when you die?
Life insurance claims can be paid out in several ways. Here are some of them.
- To an estate
If your beneficiaries are not specified as part of your life insurance policy, the proceeds will likely, by default, be treated as part of your estate. If a will was enacted, then your beneficiary wishes will be followed as closely as possible.
This is another good example of why the creation of a will is very important to ensure there is no ambiguity over your estate and your life insurance proceeds.
- To a beneficiary
If you include accurate, up-to-date beneficiary information on your life insurance policy, the money can only be claimed by the beneficiary or beneficiaries. However, there are sometimes mitigating circumstances to consider, such as an untimely death of a beneficiary. In most cases, if the listed beneficiary dies before the policyholder, the beneficiary’s heirs are entitled to the proceeds.
- Into a trust
If you set up your life insurance proceeds to be paid into a trust when you pass away, that money will be held in the trust appropriately and distributed as a claim per the instructions outlined in that trust.
Naming and paying out to a trust can be an excellent way to help mitigate inheritance taxes and may also be used to satisfy an inheritance tax bill (typically on a larger-sized estate) without needing to liquidate assets.
Will my beneficiaries have to pay taxes on the proceeds of my life insurance policy?
Good news! When considering the death benefits of a life insurance policy, the payout is generally free from any income tax to your selected beneficiary or beneficiaries.
However, you may choose to have the insurance company keep these proceeds for a while after your death so they can be distributed to your beneficiary in a series of installments or at a later date. This way, the funds may continue to earn interest. When a payment is made to your selected beneficiary later on, it may be a larger amount because of the interest earned. Note that while the principal portion of the payment is typically free of taxes, the interest portion would be taxable to the beneficiary as ordinary income, so they would be on the hook for at least some taxes in this scenario.
Finally, in some cases, if the ownership of your life insurance policy is transferred to another party for monetary value before you die, the proceeds your beneficiary receives at your death could also be considered taxable income.
We hope this information is helpful to you. As with any complicated financial matter, it’s always best to seek the assistance of a professional who can walk you through your questions and particular situation.
Life Happens, by Kirk Cremer | March 8, 2023