Life insurance provides a safety net to ensure your loved ones do not suffer financially after your death.
Should you pass away, the insurer pays your beneficiaries a sum of money called the death benefit. Keep reading to find out how the death benefit works and more.
How Do Death Benefits Work?
The death benefit is the amount a life insurer pays to the policy’s beneficiary (or beneficiaries) when the insured passes away. Generally, the death benefit is the same as the life insurance policy amount, but in some cases it can be less.
Before we look at the way death benefits work, some important points about the life insurance beneficiary.
- There can be more than one beneficiary
- Generally, people name their spouse or children as the beneficiary, but this could be anyone, including an entity
- The policyholder can add a new beneficiary or remove an existing one at any time
- If the policyholder does not name a beneficiary, the proceeds go to the deceased’s estate by default
Coming back to death benefits, here are some vital facts to keep in mind.
The death benefit can be split any way the policyholder wants
A policyholder can designate two or more beneficiaries and allocate a specific percentage or amount to each one of them.
The beneficiary is free to use the payout as they like
A life insurance death benefit does not come with any conditions or stipulations. The recipient is free to use it however they like. They can use it to take care of monthly bills or big expenses, like college tuition fees. They can also use it to pay off debts, like a mortgage or a credit card bill. If the beneficiary does not need the entire benefit amount at once, they may opt to receive it in installments or invest it for potential growth.
The payout is generally not subject to tax
When the death benefit is paid out as a lump sum, it is not subject to tax, unless the beneficiary is your estate. If your beneficiary chooses to receive the life insurance payout in installments, they will have to pay tax on the interest earned.
The insurer may sometimes pay part of the death benefit
Some life insurance policies come with an accelerated death benefit rider, while some others allow the policyholder to buy it separately. This rider allows the policyholder to receive part of the life insurance policy amount before death under certain conditions. An accelerated death benefit is paid in the scenario that the insured develops a terminal illness and is not likely to live for long.
The insurer will require the policyholder to submit proof of life expectancy. This is usually six to 12 months, but it can also be longer, depending on the insurer. The accelerated death benefit is rarely more than 50% of the life insurance policy value. Whatever money the insurer pays gets deducted from the death benefit. So, there will be less to distribute between your beneficiaries when you pass away.
The policyholder can use the accelerated death benefit to cover out-of-pocket medical bills or other expenses.
Sometimes the death benefit may be reduced
There are several situations in which the death benefit can be reduced.
- If the insurer has issued an accelerated death benefit, the amount disbursed to your beneficiaries will be less than the original policy amount.
- If the policyholder lied or withheld information while applying, the insurer may decide to pay only part of the benefit. In some cases, the insurer might not pay at all. Life insurance policies include a contestability period, which is usually two years. If the policyholder dies in the first two years of the coverage, the insurer can contest or question the claim. If a misrepresentation on the life policy application is discovered, the insurer can reduce the death benefit or deny the claim.
- If the policyholder had taken a policy loan or made a partial withdrawal, the payout will be reduced. Some life insurance policies also include a savings component, called cash value. A policyholder can access the cash value by taking a loan against it or making a withdrawal. If the policyholder takes a loan against the cash value and does not repay it or repays only a part of it, the outstanding balance is deducted from the death benefit. A partial withdrawal, on the other hand, is similar to receiving part of the death benefit early. As you may guess, each withdrawal reduces the death benefit, usually on a dollar-for-dollar basis.
How to Find Out if You are a Beneficiary?
When someone buys a life insurance policy, they should list all the necessary details regarding each beneficiary. This will allow the insurer to disburse the policy proceeds swiftly and as intended by the deceased. It is not enough to just provide the names of your beneficiaries because people can change their names. Instead, the policyholder should provide the below-motioned information for their beneficiaries.
- Full name of each beneficiary
- Date of birth
- Social Insurance Number
- If not a Canadian citizen, their nationality as well as passport number
Do not depend on the insurer to inform you that you are a beneficiary
Often, life insurers might not be looking for beneficiaries because they do not know the insured has passed away. Even when they do, tracking down beneficiaries can prove difficult due to name changes and unreported changes of address.
If you have aging parents, ask them if they have a life insurance policy and whether you are listed as one of the beneficiaries. If you are aware of such a policy, inquire if the policy is in force and where the policy documents are kept. This way you will be easily able to access them when the time comes.
What to do if you cannot locate the life insurance policy documents?
Documents can get lost or misplaced. Sometimes people pass on without sharing the information regarding their life insurance policy with their relatives. If you have a good reason to believe you are listed as a beneficiary, you can try online websites such as olhi.ca and unclaimedassets.com.
Life insurance claims do not happen automatically
Beneficiaries need to inform the insurer about the insured’s death to make a claim for the death benefit. If a loved one has passed away and you are named as beneficiary on their life insurance policy, you need the following three things to start the claiming process:
- The life insurance policy number
- The name of the insurer
- The insured’s death certificate
How to Claim a Life Insurance Benefit?
As mentioned above, it is up to the beneficiary to file a claim. Some providers let you file a claim online; others require you to fill and mail back the claim form. Either way, you can expect the insurance company to process your claim within 30-60 days of filing it. One way to ensure there are no unnecessary delays is by completing the claim form carefully and attaching all the relevant documents.
Documents needed for a life insurance claim
- Life insurance claim form
- A certified copy of the death certificate
- Policy number
Steps to file a life insurance claim
- Download the claim form from the insured’s website if available. Otherwise, contact your agent or the life insurance company to obtain one.
- Complete the life insurance claim, select a payout option, and then submit the claim form. (Some life insurance companies let you file a claim online, while others may ask you to fax or mail the completed claim form.)
- Attach a certified copy of the death certificate with the claim form. If the life insurance company asks for some other documents, provide them too. (If the insurer has an online process, upload all relevant documents.)
- The insurer is likely to release the death benefit within 30-60 days.
Receiving a Payout
You can choose how you want to receive the payout. While a lump sum is the most popular option, you might not need the entire death benefit amount right away.
Here are the different payout options that life insurers offer.
This option allows you to receive all of the money at once. You are free to use the funds however you like. You can use the lump-sum payment to pay off your mortgage, fund your child’s college education, or take care of everyday living expenses.
When you choose to receive the proceeds as a lump sum, you will not have to report it as a taxable income. This is the default life insurance settlement option. Which means if you do not specify a payout option, the life insurance company will pay the entire benefit amount in a single payment.
Pros: It gives you the most flexibility. You have full control over the money and can use it as you like.
Cons: For some people, receiving a large payout can be a bit overwhelming. They may spend it too quickly, only to regret it later.
Some insurers allow beneficiaries to convert a policy benefit amount to an annuity. A life annuity provides you with a fixed income for the rest of your life. The size of the payment depends on two factors:
- Your age at the time of the insured’s death
- The coverage amount
Pros: Life annuity payments never stop, so it can be a good option for those worried about spending a lump sum too fast. Moreover, if you live longer than the insurer expected, you could receive more than the policy amount.
Cons: If you are a young widower or widow, the guaranteed income might not amount to much. That is because the younger you are, the smaller the monthly annuity payments. Plus, if you pass away before collecting the full benefit, the insurer will keep the remaining amount.
Retained Asset Account
Some insurers give the option of leaving the payout with them in an interest-bearing account. Generally speaking, the provider will issue you a chequebook, allowing you to access the account as required. You may also be offered an interest income option, in which the insurer will pay only the interest earned on the policy amount.
Pros: This could be a good option if you are not confident about handling a large payout.
Cons: You are likely to get a better interest rate if you put the money in a traditional investment vehicle. Plus, the interest you earn on a retained asset account is taxable.
Life Income with Period Certain
This life insurance settlement option provides you with a steady income for a certain period. If you die before this period is up, your beneficiaries will receive the remaining payments. For instance, say you opt to receive payments for 10 years but die in year two. The insurer will continue to pay your beneficiaries for another eight years.
Pros: If you pass away before the selected period is up, your beneficiaries will receive payments instead of the insurer pocketing the remaining amount.
Cons: The payments are lower than what you will receive with a life insurance annuity.
Specific Income Payout
With this option, you get to choose how long you want to receive payments for and the size of the payments. For instance, if the policy amount is $500,000, you could opt to receive $50,000 per year for a period of 10 years.
Pros: Gives you more flexibility compared to the life income payout options since you can select the payment terms. This could a good option if you find a large payout overwhelming.
Cons: Any interest you earn will be subject to tax. Plus, this settlement option does not offer as much flexibility as a lump sum payout.
Proceeds of a life insurance policy are generally not taxable. However, any interest you earn on them is subject to tax. So, if you receive the death benefit as a lump sum, you will not have to pay tax on them. But if you want the death benefit paid in installments, there may be tax implications.
If you are a life insurance beneficiary, the onus is on you to contact the insurance provider after the insured’s death to start the claim process. To file a death benefit claim, you need the policy information, a copy of the death certificate, and the claim form. If you have filled out the form correctly and everything is in order, you should receive the payout within 30-60 days.