Settlement Options for Life Insurance Proceeds: Estate Planning

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1 Settlement Options for Life Insurance Proceeds: Estate Planning

2 Settlement Options for Life Insurance Proceeds: Estate Planning What are settlement options? Mode of receiving death proceeds A settlement option refers to the way in which a beneficiary chooses to receive death proceeds payable on a life insurance policy. Generally, a beneficiary can receive the proceeds in a lump sum or in installments. These choices are referred to as settlement options because the beneficiary has a claim against the insurer for the proceeds and the insurer is "settling" that claim by agreeing to pay the death benefit to the beneficiary in either a lump sum or in installments. Lump sum versus installments The beneficiary basically has two choices regarding payment of life insurance proceeds: 1) to receive the insurance proceeds all at once (in a "lump sum"); or 2) to receive the proceeds in a series of smaller payments over a period of time (in "installments"). If the beneficiary chooses to receive the proceeds in a lump sum, the death benefit will be paid to the beneficiary shortly after the decedent's death. If the beneficiary chooses to receive the proceeds in installments, the insurer retains the proceeds and makes periodic payments to the beneficiary. Generally, if the installment method is selected, interest accrues on the principal retained by the insurer, and is paid to the beneficiary with the installments. If the installment method is preferred, there are several modes to choose from. The installment method is often referred to as a "poor man's trust." Using the installment method as a trust substitute is generally not advisable, however, because a true trust is more flexible and better able to meet the beneficiary's needs. Trusts are more flexible because insurance companies are not set up to deal with the special circumstances of beneficiaries. For example, you want your beneficiary who is your minor child to receive payments of interest only until age 21 with one half of the principal payable at age 21 and the remainder payable at age 25. This is relatively easy to do with a trust but insurance companies are not set up to handle variable payment options such as this. However, the installment method does have some advantages over a true trust: There is no extra charge from the insurer for selecting this method of payment Payments of principal and interest are guaranteed (although interest generally accrues at a relatively low rate) Tip: Using the installment method as a trust substitute is generally advisable only if the amount of the proceeds is relatively small and the cost of creating a trust would be prohibitively high. What are the optional modes of settlement? Lump sum The most obvious and common method of settling is to take the proceeds all at once in a "lump sum." This method is advantageous because it allows the beneficiary to: Invest the proceeds immediately, thereby realizing potentially higher earnings than could be obtained by leaving the proceeds with the insurer Use the funds to meet his or her individual needs Page 1 of 4, see disclaimer on final page

3 Life income The life income option provides payments to the beneficiary for his or her lifetime. If the life income option is available and selected by the beneficiary, the insurer buys an annuity with the life insurance proceeds which makes periodic payments to the beneficiary. There are four basic types of annuities: Straight life: This type of annuity, which pays the highest annual income, makes fixed, periodic payments for the life of the beneficiary which cease at the beneficiary's death. Period certain: A period certain annuity makes guaranteed fixed, periodic payments to the beneficiary for a period selected by the beneficiary (e.g., 10, 15, or 20 years). The payments continue for the entire period, even if the beneficiary dies before the period ends. Generally, the beneficiary designates an individual to receive the remaining payments or possibly the remaining payments could be accelerated and paid to the beneficiary's estate. Joint and survivor: A joint and survivor annuity makes fixed, periodic payments as long as either of two beneficiaries is alive. Payments end on the death of the surviving beneficiary. Life refund: A life refund annuity makes fixed, periodic payments to the beneficiary until the amount paid out is equal to t h eamount that would have been paid to the beneficiary had the lump-sum method been selected. Interest option The interest option pays the beneficiary annual, semi-annual, quarterly, or monthly payments of interest only. The principal remains with the insurer and passes to the beneficiary's estate upon his or her death. The beneficiary may also be given an unlimited or limited right to withdraw principal. Tip: This is a great option for a beneficiary who needs time to decide how to better invest the proceeds. Fixed period This option allows payments in equal amounts over a specified period of time. If the beneficiary dies before the specified time period has elapsed, any balance remaining passes to a secondary beneficiary. Tip: This option is a good choice if the beneficiary needs larger payments over a shorter period of time. Fixed amount This option pays the beneficiary a fixed amount for as long as the proceeds last. If the beneficiary dies before the proceeds run out, the remainder passes to a secondary beneficiary. Tip: This is an attractive option for a beneficiary who needs the payments to supplement another income. Page 2 of 4, see disclaimer on final page

4 What are the income tax ramifications? Lump sum generally exempt from income tax Generally, life insurance proceeds payable in a lump sum are received by the beneficiary free from income tax. There are some exceptions to this general rule, however: Transfer-for-value rule: This rule applies where the transferee (the purchaser) has purchased the policy from the insured. Under the transfer-for-value rule, proceeds paid on a policy which was received by the transferee in exchange for consideration (money, or something of value) are subject to income tax to the extent that they exceed the value of the consideration paid, plus premiums paid by the transferee Qualified retirement plan: Proceeds received by the beneficiary under a policy purchased by a qualified retirement plan or employee benefit trust are generally taxable as ordinary income to the beneficiary to the extent that they represent the cash value of the policy at the time of the insured's death. Dividends/compensation: If the proceeds are considered dividends or compensation because a company paid the premiums on the policy and the insured was a stockholder or employee of the company, they are taxable to the beneficiary as ordinary income. Interest earned on installment payments taxable as ordinary income When payments of interest are received by the beneficiary under an installment option, the interest (but not the principal) is subject to income tax. Generally, interest is taxable as soon as it is credited to the beneficiary, even if the beneficiary does not actually receive it. Tip: Interest received by the beneficiary under a government life insurance policy is exempt from income tax. Page 3 of 4, see disclaimer on final page

5 Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual's personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable - we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice. Registered representative offering securities through SagePoint Financial, Inc., a registered broker-dealer and member FINRA/SIPC. Investment advisory services offered through Keeler Thomas, Inc., a registered investment advisor, not afiliated with SagePoint Financial, Inc South 800 East Orem, Utah Page 4 of 4 Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2015