When someone close to you dies, it can be hard to think about finances but there are several potential financial events that can come at you quickly. One consideration you may want to think about is life insurance. If you’re listed as a beneficiary on their life insurance, you may be owed some money from the insurance company. This is called a death benefit and it’s important to understand how it works if you’re listed as a beneficiary. Whenever receiving any money you may want to consider working with a financial advisor to see what impact it might have on your overall financial picture.
What Is a Death Benefit?
A death benefit is the payout of the life insurance policy, annuity, retirement account or pension. When the policyholder dies, the death benefit will go to whoever is listed as a beneficiary. If there is no beneficiary then it goes through the normal probate process. The specifics of the death benefit depending on its type and the options the policyholder chose. Usually, beneficiaries are spouses, children or other family members.
Death benefits are paid out to beneficiaries when the policyholder passes. With life insurance policies, policyholders instruct the insurance company how to pay out the death benefit. For instance, say you have two children as beneficiaries: one who’s 18 and another who’s 30. You could have the death benefit paid out in full for the 30-year-old, where the 18-year-old gets a portion at 18, another at 24 and the remainder at 30.
Death benefits don’t pay out automatically. To receive the death benefit, beneficiaries must file a claim. Paperwork, such as the policyholder’s death certificate and the policy number, will be required to complete the claims process. Payouts typically happen 30 – 60 days from when the claim is filed.
Why Can Death Benefits Be Denied or Reduced?
Unfortunately, sometimes death benefit claims are denied. This can happen for a variety of reasons. For example, if the deceased held a term life insurance policy and died outside of the term, there are no death benefits to be claimed. Similarly, if the deceased stopped making monthly payments on their life insurance policy before their death, it could be grounds for denial.
Another major reason for denial is if the cause of death is excluded. Wars, suicide and even dangerous sports can be causes for denial. The details of which should be outlined in the policy and any of your questions should be answered by the life insurance agent familiar with the policy.
Benefits can also be reduced for other reasons. One common reduction is called a graded death benefit, which lowers the benefit if the policyholder dies just a short time after taking out the policy. The specific length of time depends on state law and the policy itself.
Death Benefit Types
Depending on how and when the policyholder dies, as well as other specifics in the life insurance policy, there are different types of death benefits. Here are five different types of death benefits:
Pension Death Benefits: If a pensioner dies before the assets in the pension are completely paid out, what’s left over will be paid out to beneficiaries.
Annuity Death Benefits: When an annuity contract holder dies, the annuity is awarded to the beneficiaries.
All-Cause Death Benefit: A life insurance policy that pays out regardless of how the policyholder dies, unless specifically excluded by the policy.
Accidental Death Benefit (ADB): These are life insurance policies that only pay out due to a qualifying accident, such as a car crash. What qualifies depends on the insurer and the policy.
Accidental Death and Dismemberment (AD&D): Similar to an ADB, but also pays out due to an accident that causes blindness, paralysis or maiming.
Options for Death Benefit Payout
If you’re set to receive a death benefit from a life insurance company, you may have the option of how it’s paid out. It’s important to understand the differences as each could impact your finances differently. Here are some of the most common ways death benefits are paid out:
Lump Sum: This is the most common way to receive a payout. The life insurance company will cut you a check or wire the whole benefit into your bank account.
Installments: Instead of the lump sum, you can choose to get the death benefit in installments. These can come at whatever amount you determine you need and can be a good option if you want to subsidize your income every month.
An Annuity: If you don’t need the money right away, you could elect to have the money put into an annuity. This will cause the money to build in interest but will limit your liquidity.
Retained Asset Account: You could elect to have the money put into a retained asset account. These accounts earn a small amount of interest and can still let you access your funds.
Do You Have to Pay Taxes on a Death Benefit Payout?
Whether you have to pay taxes depends on the type of death benefit policy. Life insurance death benefit payouts are tax-free, whereas beneficiaries will need to pay taxes on annuity earnings and death benefits received from pensions, 401(k)s and IRAs. These taxes may include extra income taxes or capital gains taxes.
The Bottom Line
Nobody wants to think about how their death could affect the ones they love. But the truth is that it’s better to plan than to leave things to chance. Knowing how your death benefits work will help your beneficiaries when the time comes. And if you have aging parents or other family members, consider broaching the subject with them so you know what their wishes are when they go.
Financial Security Tips
Your selection of an insurance policy can have a major impact on your finances, as well as your beneficiaries’ finances. If you’re unsure of which policy to go with, a financial advisor may be able to help. Finding the right financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Want a better way to understand how much life insurance you should buy? Our free life insurance calculator can give you a solid estimate of what’s right for you and your loved ones.
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