Life Insurance: Everything You Need to Know About Your Settlement Options | INVESTEDMOM
No one likes to talk about dying, but the truth is 100% of us are going to at some point. Being prepared is essential to ensure our families are cared for no matter what comes their way.
Did you know that according to a recent study, only 59% of parents of minor children have life insurance? This statistic means that if something were to happen to one of the parents, that loss of income would not be covered and could leave the rest of the family scrambling to make ends meet. Even insurance for a non-working partner is essential to cover potential medical bills, funeral costs, and childcare expenses.
Selecting insurance isn't just about picking a value, though. It's about choosing the specific insurance that will help maximize the benefits best for your family's unique situation and help you create financial peace of mind.
In this article, we will discuss life insurance and its types, learn the basics of life insurance settlement options, and discuss how to choose the right settlement option while considering tax implications and special circumstances.
What is Life Insurance?
Life insurance is a contract between an individual, who is the policy owner, and a life insurance company. The life insurance policy typically requires the insured person to pay a premium, and the insurer then pays a designated sum of money when the insured dies.
There are several types of life insurance policies that we could get into, but let’s focus on the most commonly utilized.
Term Life Insurance
Term life insurance provides coverage for a specific period of time, such as 10, 20, or 30 years. The beneficiaries pay the death benefit if the insured person dies during that time. If the term ends and the person is still alive, there is no payout, and the policy ends.
Whole Life Insurance
Whole life insurance or permanent insurance provides coverage for the policyholder's entire lifetime. This type of coverage builds a cash value over time that a policyholder can borrow against or withdraw. Because of this benefit, premiums are typically higher than term insurance.
Universal Life Insurance
Universal life insurance is a type of whole life insurance, but it offers more flexibility. The policy accumulates a cash value normally tied to a financial index, and you can withdraw if needed before death.
Variable Life Insurance
Last, but not least, variable life insurance combines life insurance with investment opportunities! These plans offer the most flexibility but are more complicated than their counterparts if you hope to manage it yourself.
Regardless of where you are in life, insurance will protect the ones you love from unexpected expenses that will leave them struggling with more than just the loss of someone they love.
The Basics of Life Insurance Settlements
We've discussed insurance options; now, let's talk about settlements. A life insurance settlement is selling a life insurance policy to a third party.
Choosing the right settlement option is essential to meet the beneficiary's needs. Factors to consider include:
Financial Needs: A lump sum payment is excellent for someone facing urgent financial needs. However, a payout over time is a better option if the beneficiary seeks long-term stability to cover ongoing expenses.
Maximizing Policy Value: A life insurance payout may be higher if taken out over time rather than a lump sum payment. Look into the values of payout options to ensure you are getting the greatest value.
There are many policy types, and the policyholder's age influences many of them. If you are unsure of the payout options for your insurance, contact the insurance company and request to review the payout options for your specific policy before you make any decisions.
Types of Life Insurance Settlement Options
Now, into the nitty gritty. Before making your payout decision, ensure you know all the options available for your specific life insurance claim. The most common payout options include:
Lump-Sum Payment
A lump sum payout is straightforward. The beneficiary receives the entire death benefit in a single payment after the insured's death.
Interest Income Option
The interest income option is where the insurance company retains the money from the policy and pays the beneficiary interest on the death benefit. The principal can be withdrawn at any time.
Fixed Period Option
The fixed period option sets up a payment schedule where the death benefit and interest payments are paid to the beneficiary over 5, 10, or 20 years.
Life Income Option
The life income option is an arrangement where the beneficiary receives payments for the rest of their lives. The payment amount depends on the beneficiary's life expectancy.
Fixed Amount Option
The fixed amount option allows the beneficiary to receive a set amount regularly until the life insurance death benefit and interest are depleted.
Deferred Payment Option
The deferred payment option allows the death benefit to remain with the insurance company and earn interest until the beneficiary is ready to cash out.
Joint and Survivor Life Income Option
The joint and survivor life insurance payout option, allows income for multiple beneficiaries to receive payments as long as one beneficiary remains alive, and payments may increase when one beneficiary dies.
How to Choose the Right Settlement Option
Choosing the right life settlement option may seem overwhelming. There are a lot of variables to consider, but consider the following, and it will help you make the right decision.
Know which life settlement options are available through the policy's death benefit.
Assess the needs of the beneficiary and their family.
Understand the financial situation of the beneficiaries.
Take into account current and future expenses.
If you need further guidance, consult a financial advisor to help choose the best way to utilize the death benefits.
Tax Implications
I have some great news! In most cases, money received from a death benefit by a beneficiary is not taxable income - unless the policy is transferred or sold to the beneficiary.
There are settlement options that will lead to taxable income. Some ways this can happen include:
Tax on the Gain: if there is a difference between the settlement amount and the total premiums paid.
Capital Gains: if the settlement exceeds the policy's cash surrender value.
Interest: earned on the settlement if a death benefit is paid over time or left within the insurer to earn interest.
Structured settlement options spread the tax burden over time, especially when there are vast amounts of interest. To minimize tax liability, avoid transfers without understanding tax implications, and consult a tax professional if unsure of the best steps.
Common Mistakes and Special Circumstances
There are many common mistakes that are easily avoidable when cashing in a death benefit. These include:
Not reviewing options thoroughly
Not shopping around when selecting an insurance company
Selling too early when the money isn't immediately needed
Overlooking the needs of the beneficiaries and their dependents
Failing to consult with financial professionals
Last, but definitely not least, there are some special circumstances to consider when settling a life insurance policy.
If you or someone you know is terminally or chronically ill, you may be eligible for a viatical settlement, which is where you can sell your policy tax-free.
Some other common circumstances include the following:
Divorce: If a life insurance policy was purchased during marriage, and there is a divorce, it's generally treated as an asset that must be split.
Estate Planning: A life insurance claim can significantly impact estate planning. For example, if an individual's estate is the primary asset, a life settlement can cover the costs of tax, debt, etc. If a policy is held within an ILIT (Irrevocable Life Insurance Trust), selling it becomes more complicated, and I highly recommend consulting a professional.
Bankruptcy: If a person is facing bankruptcy, a life insurance cash value may be considered an asset. Some types of insurance do offer protection from creditors, so it's essential to know your individual plan.
Know Your Options to Ensure You Select the Best Settlement Option for You!
Regardless of the type of life insurance you purchase, it will benefit your family when the inevitable happens.
If you hope to use your life insurance as an investment opportunity, ensure you look into whole, universal, or variable life insurance policies.
When deciding on a life insurance settlement, remember to consider the current and future financial needs and research the individual policy to ensure you maximize its value. Avoid the common mistakes of not reviewing policies properly, not shopping around, selling too early, overlooking the needs of the beneficiaries, and always consult a professional if you are unsure about tax implications and special circumstances.
If you want to learn more about how to successfully manage your finances, check out my new book, Wealth Building Framework. At Invested Mom, I am here to help empower you towards a brighter financial future.
Meet the Author:
Inge was born and raised in Cape Town, South Africa, and moved to Canada in 2010 looking for a better life. She always had an entrepreneurial spirit and started her first side hustle when she was 9 years old – selling fudge at school during lunch breaks.
It wasn’t until much later that she realized that saving isn’t enough to get ahead. She was always very interested in real estate, but saving up for a down payment was grueling and slow, and the demands of life kept getting in the way.
She started investing in herself and upgrading her skills while learning how to invest. She quickly became debt free and compounded her money at a staggering rate.
It wasn’t until she became a coach that she realized how significant an impact she can make in people’s lives by sharing her journey, learnings, and processes.
So here she is, advocating for everyone who is invested and wants to build their wealth, especially the mommas!