What You Need to Know About Life Insurance Death Benefits

iQuanti: You may have already purchased life insurance on your own or received coverage through a group policy by your employer. However, beyond a basic understanding of how does life insurance work, do you really know the ways these death benefits will be paid out? Here are five important facts for you to know about the proceeds of a life insurance contract.
1) Benefits are Tax-Free
One of the most lucrative features of a life insurance contract is that death benefits are paid out to beneficiaries tax-free. Since these proceeds are considered a payout from a contract and not a transfer of assets, the IRS sees them as exempt from income tax.
The only time taxes will apply is if any income is generated on top of the death benefit. For example, if there is a delay between when the policyholder passes away and when the beneficiaries receive their payments, then the interest earned in between these events will be considered taxable. Likewise, if the payments are broken up over the course of several years and interest is added on top, then the interest portion of the payment will be considered taxable income.
2) The Provider Will Only Pay Your Designated Beneficiaries
Some people falsely believe that the death benefit from a life insurance policy will automatically be paid to their heirs. However, an heir (such as a family member) and an insurance beneficiary are not necessarily the same.
Insurance beneficiaries are the people or entities you have specifically listed on your policy. They could be family members as well as non-family members. Some people even list trusts and charities as beneficiaries.
Regardless of who they are, the life insurance company will only pay out to the beneficiaries you have listed on the contract. This could create a very messy situation if you remarry but forget to take your ex-spouse off your policy. To avoid this altogether, remember to check your beneficiaries annually and make sure that the benefits will go to the people you want them to.
3) Distributions Take Place Outside of Probate
Another big advantage to life insurance payouts is that they are considered non-probate assets. Probate is the court proceedings that occur after a person has passed away, and it must now be decided how the deceased’s estate will be divided.
Again, because life insurance is a contract, the provider can legally distribute the proceeds directly to the beneficiaries outside of probate. This is also one of the reasons why financial experts often discourage listing your estate as the beneficiary on your life insurance policy.
4) Benefits Can Be Used for Anything
Beneficiaries are allowed to use the death benefit for any purpose they wish. Surviving spouses commonly treat these proceeds as a source of income replacement. However, there is nothing to stop a beneficiary from using the death benefits for other noble purposes like:
5) Borrowed Cash Value Will Be Subtracted
If the life insurance were a permanent policy, it would have cash value. If the policyholder borrowed against its cash value, then this debt must be repaid to the insurance company. Thus, it will be settled by the life insurance company by simply subtracting it from the death benefit payout.
The Bottom Line
There are several caveats to keep in mind regarding life insurance death benefits. While some may be positive such as tax-free distributions outside of probate, know that these will only go to the beneficiaries listed on the contract and can be used for any purpose. Also, if you borrow against the policy’s cash value, this will be subtracted from the death benefit scheduled to be paid to the beneficiaries.
Source: iQuanti