The death benefit is the amount of money that is paid out when a valid life insurance claim is filed. The death benefit is paid to the stated beneficiaries of the contract, which are determined by the owner before the insured person is deceased. The death benefit is used to provide income for those that rely on the insured person as a provider.
If no beneficiaries remain living, or if no beneficiaries are stated on the contract, the full value will normally go to the estate of the insured. The estate is subject to probate and any applicable taxation. The death benefit is normally tax-free if a living beneficiary is named.
In this Article we Cover:
Why Death Benefits can be so Large
When Death Benefit Is Paid
Taxation of Death Benefit
Uses for Death Benefit
Death Benefit is the Original Purpose of Life Insurance
The death benefit paid is most often also the same as the face amount of the contract. The face amount is the initial amount of money, which is stated on the face of the contract, that will be paid in a death claim. The face amount, and thereby the death benefit, can change for a number of reasons but it is much more difficult to increase a death benefit substantially than to decrease it in most circumstances.
The reasons for a change in the death benefit can include additional paid-up insurance bought with dividends, and having an increasing death benefit based on the cash value such as with a universal life insurance policy. A face amount can change under certain circumstances such as when someone performs a face amount reduction for the purpose of saving money.
Do not assume that the face amount is the same as the death benefit when it comes to permanent life insurance. A death benefit can also be reduced by loans or partial surrenders when the owner takes money out of a policy. With term life insurance, the face amount and the death benefit are the same.
Why Death Benefits can be so Large
Many people are shocked at what appears to be huge sums of money in life insurance death benefits. Often times, the death benefit of life insurance policies can even surpass seven figures. While these sums may appear ostentatious at first glance, there is a good reason for them. If someone who makes $75,000 per year passes away at 40 years old, they can reasonably be expected to have had at least 20 to 30 years of income-earning years ahead of them. Even without a raise in pay, 25 years of $75,000 pay is $1,875,000 in lost income. It is quite expensive to pay off a mortgage, and pay for children’s education, and fund a spouse’s retirement. Large death benefits are both reasonable and necessary.
When Death Benefit Is Paid
Normally the death benefit is only paid upon receiving a valid death claim from the beneficiaries of a life insurance contract. To qualify as a valid claim, the reason for death must not be precluded by the insurance contract.
The life insurance company must have an original death certificate on file in most cases and receive properly filled out valid claim paperwork. When all conditions are met for a valid claim, a life insurance company must make a timely payout of the full amount to the beneficiaries as required by law.
The exact amount of processing time between a company receiving all valid claim files and actual claim payout can vary from state to state and company to company, but generally, this will take place within a two-month time frame. Often times claims are paid even faster.
Taxation of Death Benefit
Life insurance death claim benefits are almost never taxable if planned correctly. This means that generally speaking an insured person can pass along money to heirs without incurring any estate taxes on the proceeds of the death benefits. There are some requirements regarding ownership of the policy before and at the death of the insured for the benefit to qualify as tax-free in some circumstances. It is also important to remember that to bypass the estate, a living beneficiary must be named. If there is not one named then the money will be paid to the estate and subject to probate.
Generally speaking, the policy must be owned by someone other than the insured for at least three years prior to death in order to avoid taxation as part of the estate. Proper planning such as placing ownership in a trust can avoid these taxation issues.
Uses For Death Benefit
The most obvious use for a death benefit payment is to provide income for loved ones. Sometimes this goes to a spouse which helps them pay expenses such as a mortgage, childcare, or to help fund retirement. Money may also go to children to pay for an education, or even to leave them financially comfortable. Life insurance can take care of a family financially, and make life easier. It can also leave a nice legacy or nest egg to those that are left behind.
Some people may be surprised to learn that there are many other uses for a death benefit too. Life insurance is a very flexible tool that can solve a number of different financial planning needs. Here are some other common uses.
Paying Estate Taxes
If an estate is very large, the taxes due may be very high when the estate is passed on to heirs. Some assets are not readily liquid, such as a real estate property or a piece of artwork, but taxes on the value of the items are still assessed by the IRS. This is especially cumbersome if the value of the items is high. An heir will not necessarily possess the money needed to pay the tax on the item without actually selling the item itself. The need for funds to pay for the estate taxes may force an heir to sell a very sentimental item, and sometimes at a discount in order to liquidate it in a reasonable amount of time.
Life insurance can allow an heir to inherit an item such as a treasured family lake house without having to sell the property itself. It can also help avoid disputes if more than one heir is the beneficiary of an illiquid item such as a house. Sometimes one heir may have the funds needed to pay the tax without selling the property, but the other heir does not. This can lead to disputes over whether or not to sell.
When the death benefit is used to provide liquidity to pay taxes on an estate it helps facilitate a smooth transition to heirs, helps them avoid selling an item with sentimental qualities or an otherwise useful asset to pay taxes, and does not burden heirs with tax liabilities.
Key Man Insurance For A Company
An important person at a company may be very valuable to the success of the company. If this person were to pass away, the company may incur costs replacing the person, or may it may dampen the future business opportunities of the company.
To help a company navigate this transition and to help ease the financial loss of losing a key member, it is permissible for a company to own “key man” life insurance on a member or owner. It is common amongst business partners to take out “key man” life insurance policies on each other to both ease the burden of loss on the company and to help cover the taxes on the transfer of ownership to the remaining partner or partners.
While key man insurance is taken out on women as commonly as it is on men, the old anachronisms are sometimes hard to change.
Funding A Trust Or Passing Liquid Assets To Heirs Tax-Free
Life insurance death benefits are generally not taxed. If an estate contains a large number of liquid cash assets, it may not be tax efficient to pass these along as cash to heirs. Instead, if the cash is invested in a whole life or other permanent life insurance policy, the payout from the policy will not be taxed. It is also possible depending on the age of death that there will be an additional return to the heirs and a higher total amount can be given. This makes life insurance an especially attractive way to give cash to heirs, without it being taxed as part of the estate. There are some requirements that must be met regarding ownership rights of the policy to keep life insurance benefits tax free to heirs. We always recommend that you seek guidance from a certified tax adviser when considering taxation issues.
Amount Of Death Benefit Needed
The amount of death benefit needed is very specific to each individual situation, and we advise that you always consult with a financial planner when determining specific needs. There is, however, a simple method for determining needs for loved ones in the event of an early passing that we would like to share.
A good, simple calculation sometimes used is calculated as follows. Start by taking the income earned by the insured, calculate the total amount that would be lost if the insured died today and assume he/she will earn the same amount until retirement, and add burial and grieving costs such as lost work time. Here is a hypothetical example to illustrate this calculation:
Fred is 38 years old and earns $40,000 per year. He is planning on working until he is 70, and burial and grieving costs will be $30,000. Fred has 32 years of earning income until he retires. At an earning level of $40,000, multiplied by the 32 years, we can expect that about $1,280,000 of future earnings are now foregone in the case of a death. When the $30,000 estimate of burial and grieving expenses are added, we arrive at a figure of $1,310,000. A simple calculation of the cost of Fred’s death to his family is $1,310,000. This calculation does not take into account possible raises or career advancements of Fred, or the reduced income need of the family with one less person, but it is a suitable estimate nonetheless.
If Fred compares life insurance quotes for this amount, he can find the least expensive life insurance policy that will provide the protection he desires for his family.
Death Benefit Is Original Purpose Of Life Insurance
While life insurance has evolved to become a savings, investment, and tax optimization tool, the original and primary purpose is to provide a death benefit to beneficiaries upon the death of an insured. The death benefit is determined at the time of the contract issuance, and under normal circumstances does not change substantially during the lifetime of the policy. Life insurance is often sold as an investment, and it can be. It is important to not forget that the main purpose of life insurance should be to provide for loved ones during an untimely passing.