Settlement Options on Life Insurance Policies

The settlement option on a life insurance policy instructs the life insurance company how to pay the death benefit at policy claim time.  Traditionally, the policy owner chooses the settlement option, but the beneficiary has the option to change it at claim time.  In some unique situations, the settlement option selected by the policy owner is irrevocable and the beneficiary must receive the death benefit under whatever payment schedule the policy owner chose.

The Four Most Common Settlement Options

The four most common settlement options are:

1. Lump Sum
2. Specified Years
3. Specified Amount
4. Interest Only

The lump sum settlement option is by far the most common settlement option, and it's usually the default settlement option.  Under this option, the life insurer pays the beneficiary the lump sum total death benefit of the policy.  The beneficiary of the life insurance policy will receive the entire death benefit payment as a single payment (lump sum payment) and have no future dealings with the life insurance company regarding the payment of the death benefit.

A policy owner can choose to have the death benefit of a life insurance policy paid to the beneficiary over a specified number of years.  Under this settlement option, the policy owner selects a certain number of years that the life insurer should payout the death benefit to the beneficiary.  For example, say the policy owner wanted the beneficiary to receive the death benefit over a 10 year period.  At death of the insured, the life insurance company will begin making payments to the beneficiary from the death benefit, and will stretch the payment out over 10 years.

Because life insurers must pay interest on death benefit funds that it does not pay 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 it pays out the death benefit.

Instead of choosing a specific number of years, a policy owner could select a specific amount for the insurance company to pay the beneficiary each year.  The insurer will do begin paying the beneficiary this amount annually (or in some cases might break it up into a monthly payment if the insurer allows that option) until the entire death benefit amount reaches zero.  Again, because the insurer pays interest on any death benefit sum held longer than 30 days, this settlement option will result in interest earned on the death benefit sum that remains at the insurance company.

A far less common settlement option is an interest only payment the insurance company will make to the beneficiary.  Under this option, the beneficiary will receive a payment of the interest earned on the death benefit sum; the death benefit will remain at the insurance company.  Usually, the insurer will not hold the entire death benefit indefinitely, but will instead make interest only payments to the beneficiary for a certain period of time and then eventually pay the death benefit amount to the beneficiary.  You should know that this option is different from a Retained Asset Account, which is available on any death benefit payout option.

What is the Purpose of the Settlement Option?

The usual purpose of a settlement option is to give the policy owner some control over how the death benefit of his/her policy gets distributed to his/her beneficiary(ies).  In many cases, the settlement option may become a spendthrift-like mechanism that limits the amount of money that a beneficiary has at any one time, but it's a rather weak tool at accomplishing this.

This might come into play when either the policy owner or beneficiary worries about how well the beneficiary will manage the death benefit funds.  It might also help prevent the stressful decisions a beneficiary could face when deciding what to do with a large sum of money.

Tax Consequences

In general, beneficiaries receive the death benefit of a life insurance policy income tax free.  Interest paid by an insurance company on a death benefit, however, is taxable as ordinary income to the beneficiary.  So while the entire death benefit amount remains tax free, any interest earned on it will be taxable.

This means anytime a settlement option results in interest payments to a beneficiary, the interest earned will result in reportable income paid by the insurance company to the beneficiary.

For a lump sum settlement option, the most common way a beneficiary might earn interest on the death benefit is a processing delay.  If the insurance company does not pay the entire death benefit to the beneficiary within a specific period of time (usually 30 days) the life insurer owes the beneficiary interest on the death benefit.  In addition, if the beneficiary does not file the claim immediately upon the death of the insured, the life insurer will owe the beneficiary interest for the time that passed between death and when the beneficiary filed the claim.

For example, assume that Sue did not file the claims on a life insurance policy on her husband Ned until one year after he died.  In this case, the insurer will owe Sue interest on the death benefit for the year that it had her money.  It's very rare for people to not file a death benefit claim, but it's also not unheard of.

In the case of a specified number of years settlement option, the insurer owes the beneficiary interest on the remaining death benefit it doesn't pay him/her throughout each year.  This interest usually adds to the balance of the money held at the insurer awaiting payment to the beneficiary, but the interest earnings are taxable to the beneficiary in the year received.

Similarly, when using a specific amount option, the insurer will owe interest on the sum remaining at the insurance company.  This interest payment also generally adds to the sum held at the insurance company but is taxable income to the beneficiary in the year the interest payment occurs.

In the case of an interest only settlement option, the entire payment made to the beneficiary is taxable as ordinary income because it's entirely interest earnings paid on the death benefit that remains at the life insurance company.

How using the Option Works

The policy owner can choose a life insurance settlement option at policy issue or at anytime throughout the life of the policy while the insured is alive.  Usually the policy owner has the option to change the selected option whenever he/she sees fit.  If the policy owner makes no specific settlement option election, the lump sum option is usually the default.

Upon the death of the insured, the beneficiary will file a claim with the insurance company.  At this point, the insurer will notify the beneficiary of the settlement option.  In most cases the beneficiary can accept the option the policy owner selected or change it to one that he/she feels fit his/her needs.  It's also usually the case that the beneficiary can change the settlement option if he/she chose either the specified number of years, specified payment, or interest only payment to a lump sum payment at some point in the future.  In this case, the beneficiary is simply telling the insurer to take whatever the remaining balance is and give to him/her.

For example, assume that Vince's father chose the specified number of years settlement option stretching the payment of the death benefit out over 15 years.  Vince received payments for five years and then decided that he no longer wishes to receive the death benefit as a systematic payment.  Vince contacts the insurer and requests the rest of the money.  The insurer will end the payment to Vince and simply pay him the balance of cash held at the insurance company.

Strengths and Weaknesses of Settlement Options

Settlement options can meet the needs of common financial worries a beneficiary or policy owner might have about managing a large payout from a life insurance policy.  But, the methods settlement options use to limit the mount of money a beneficiary will receive at one time are largely voluntary on the behalf of the beneficiary.

This means that if the policy owner has serious concerns about the beneficiary's ability or willingness to accept the limited payout from certain settlement options, the policy owner may require stronger legal impediments to the money such as a trust that receives the death benefit proceeds.  The settlement option is not a substitute for more specialized legal and/or financial planning that seeks to protect beneficiaries from things such as bad financial habits or predatory financial advice.

Settlement options are instead best thought of as helpful systems to organize the distributions of funds in manner more conducive to how a majority of Americans manage their financial lives.