How Do Life Insurance Payouts Work?

An elderly couple is at their kitchen signing a document while the woman embraces the man.

Life insurance payouts are sent to the beneficiaries listed on your policy when you pass away. But your loved ones don't have to receive the money all at once. They can choose to get the proceeds through a series of payments or put the funds in an interest-earning account.

Read on to learn more about how life insurance works, the different payout options and if a policy is a good investment

What Is Life Insurance and How Does It Work?

At its most basic, life insurance works like homeowners or auto insurance: You pay an annual premium in exchange for a certain amount of coverage. If you pass away while the policy is active, your beneficiaries receive a death benefit equal to the coverage amount. The main difference between life insurance and other types of insurance is that some policies allow you to accumulate cash value on the policy, which you can use a few different ways.

There are two basic types of life insurance:

  • Term life insurance: These policies provide coverage for a set period, typically between one and 30 years. Premiums are usually the same for policy's duration, and your policy pays out a death benefit if you pass away during the covered term. You earn no cash value with term life insurance—a payout only happens if you die—making it similar to other forms of insurance.
  • Whole life insurance: This is the most common form of permanent life insurance, which remains intact as long as you live, assuming you keep up with the premium payments. Cash value on your policy builds up while you're alive, and you can borrow against this amount or withdraw the funds for personal use. (Withdrawing funds lowers the death benefit, and you will have to cancel or surrender the policy if the cash value reaches zero.) You also can trade in the cash value to increase the death benefit amount.

Life Insurance Payout Options

Beneficiaries on life insurance policies have to file a claim to collect the death benefit. Most insurance companies process claims within a few days or weeks of receiving the completed claim form and a certified copy of the death certificate. However, there could be delays if the policy was recently purchased and the insurance company has reason to believe fraud may have occurred when the policy was issued.

Assuming the claim is approved, beneficiaries choose how to receive the death benefit. In most cases, proceeds can be paid out through one of the following options:

  • Lump-sum fixed amount: Beneficiaries who select this option receive the entire death benefit in one payment. It's the most common selection but can be risky if the funds are not managed properly. Because bank account balances are only covered up to $250,000 by the Federal Deposit Insurance Corporation, it may be necessary to place funds in various accounts if the insurance payout exceeds this amount.
  • Specific income payout: Your beneficiaries can choose to receive monthly installments over a set period to ensure the money doesn't run out too fast. To illustrate, they could request $30,000 in payments each year for 20 years if the death benefit was $600,000. The life insurance company will hold the money in an interest-earning account, and you'll owe taxes on the interest earned on the balance.
  • Retained asset account: If your insurance company offers this option, policy proceeds can be placed in an interest-bearing account. Beneficiaries receive a checkbook if they need to access the cash, and any interest earned is taxable. Also, the insurance company guarantees the proceeds in the account, even if the balance exceeds the $250,000 limit set forth by the FDIC.
  • Annuity: Also known as a life income payout, this grants beneficiaries guaranteed payments as long as they're alive. Insurance companies use your beneficiaries' ages when they file the claim and the amount of the death benefit to determine the payment amount. The amount of the death benefit remaining (if any) when your beneficiary passes away goes back to the insurance company unless they opt to receive an annuity for a set period. In this case, what's left will then go to designated beneficiaries.

Who Needs Life Insurance?

Life insurance can give your loved ones security and peace of mind if you pass away. It can help cover your final expenses, including funeral costs and outstanding debts that you cosign with a spouse, along with the costs associated with caring for your dependents.

But is life insurance a good investment for you? It depends. If you're single with no dependents and have enough money saved to cover your final expenses and debts if you pass away, you may not need a policy. However, you may want or need life insurance coverage if:

  • You have dependents who rely on your income for survival.
  • You're the sole wage earner in your home.
  • You're a stay-at-home parent who handles most of the housekeeping and child care duties.
  • You provide financial support for aging parents.
  • You're an empty-nester or don't have children, but provide financial support for your spouse.

If you decide life insurance is a good option for you, you have to decide how much life insurance you need and whether a term or whole life policy is a better fit. Consult with a reputable insurance agent to learn more about what options may be available to you.

Which Life Insurance Payout Option Is Best?

Life insurance can help your family cover your final expenses and fill a financial void if you pass away. There are different types of policies to choose from, and you should work with a financial planner to determine how much you need.

Also, be mindful that your beneficiaries will have the right to decide how they receive the death benefit. So, it's ideal to have a conversation about life insurance payout options with your beneficiaries to ensure they understand the options available to them and can make an informed decision when the time comes.