Life insurance death benefit is one of the most commonly used phrases in the life insurance industry. However, as simple as it appears to be, most consumers can’t distinguish between death benefit, face amount, or cash value. The death benefit which your beneficiaries will collect upon your passing away has many implications and can be varied based on the policy type, outstanding loans, and the way in which it is paid to them.
What Is Death Benefit?
Life insurance death benefit is the sum of money an insurer pays to beneficiaries upon your death, provided the coverage was in force at the time of the event. The death benefit amount is determined when you first buy the policy and, in many instances, is equivalent to the face amount or face value.
However, just because the amount of coverage you bought (face amount) is declared on the application, it doesn’t mean your beneficiaries will receive that amount upon your death (death benefit).
When Is the Death Benefit Not Equal to the Face Amount?
The face amount is the initial amount of money stated on the application when you first buy the policy and is intended to be paid as a death benefit to your heirs. The death benefit is the actual amount the carrier pays your beneficiaries. Typically, the contract’s face amount or face value is the death benefit your recipients will collect, however, there a few cases in which the death benefit does not equal the face amount.
- Accelerated death benefit: If you were diagnosed with a terminal illness and utilized the option to accelerate a portion of the death benefit amount (typically 25%–75% of the face amount), and later passed away, your beneficiaries will collect the face amount minus the amount you took while you were still alive. Some companies also charge a fee to exercise this option, so you will be paying that fee, too.
- Loans or withdrawals: If you have a permanent policy which has accumulated cash value and you took a loan, it would be treated as a lien on your death benefit. In other words, if you didn’t repay the loan, your beneficiaries will collect the death benefit minus the loan and accrued interest.
- Universal life policy: If you have universal life coverage, you have a unique opportunity to choose between two death benefit options:
- Option A: Also called level death benefit, your beneficiaries will collect the purchased face amount when you first got the policy.
- Option B: Also called increasing death benefit because your beneficiaries will collect the face amount plus the cash value that was accumulated throughout the years.
- Graded benefit policy: When buying guaranteed issue life insurance or a graded benefit plan, your face amount on the application pays a different death amount if you die within two years after purchasing the policy. For instance, if you bought $10,000 in face amount and died six months later, your beneficiaries will collect the amount of paid premiums plus 10% in interest and not the asserted face amount of $10,000 on the application.
Is the Death Benefit Taxable?
Death benefit proceeds paid to your beneficiaries in a lump sum, whether a person or an institution, is not subject to a taxable income. If you died owning a policy with a $200,000 in death benefit, your designated recipient will not pay income tax on the amount.
This is true whether you paid all the premiums yourself or your employer subsidized part or all of the premiums under a group life insurance. The exception to the rule is if the beneficiary chooses to receive the funds throughout years instead of a lump sum, the interest on the original amount is taxable while the principal portion is tax-free.
How to Choose the Death Benefit Amount
This headline is another matter and is a good idea for a complete post. Without going too much off topic here, the death benefit you chose when you first signed up for the policy must reflect your financial goals, liabilities, and income. If your purpose for buying life insurance is income replacement, a simple but effective rule to follow is to multiply your yearly income times ten.
This should give your beneficiary sufficient time to get back to life while having the same lifestyle they were used to before your death. If your ideal coverage is needed to cover burial expenses and nothing else, a $10,000–$15,000 death benefit will do just fine. We concentrate too much on the amount rather than the objective the policy for which was bought in the first place.
Don’t Confuse Death Benefit and Cash Value
Cash value refers to the savings portion a permanent coverage such as whole life or universal life insurance offers. When paying for coverage, a part of the premium payment goes for the cost of insurance (COI), and the remainder accumulates dividends and interest (depending on the policy type and carrier) in a cash account. The policy owner can do a few things with the cash in the policy:
- Make withdrawals. If you don’t pay it back, it would be reduced from the death benefit amount.
- Take a loan. The loan is subject to interest and if not paid back, would be deducted from the death benefit.
- Surrender the policy and collect all the cash value in the account. If you cancel your policy, you are entitled to the cash, however, this would terminate your coverage.
- If you have a universal life policy, you can use the cash account to pay premiums, provided there is enough cash.
How a Death Benefit Can Help
Arguably, no amount of money in the world can ease the continuous emotional distress your loved ones may have to go through upon your death. A life insurance death benefit can only reduce the financial burden and give the beneficiaries an opportunity to get back to living. This is why it’s imperative you buy the right coverage for your circumstances and weigh it carefully before obtaining your policy. Here are a few examples of how a death benefit can be used:
- A partial income replacement. Your beneficiaries can supplement the lifestyle they have become accustomed to, pay an outstanding mortgage loan, or pay school tuition.
- The final expense and burial costs. Usually, small whole life policies to cover costs that are related to your passing away such as cremation, burial, and final medical bills.
- Leaving a legacy. Your death benefit can support causes that are dear to your heart such as universities, hospitals, or any charity you like.
Life insurance death benefit is the primary reason for buying life insurance. You’ve worked hard all your life to build a life for yourself and your loved ones. Understanding life insurance death benefit and how your beneficiaries can use it once you are no longer here is a reminder of why you bought the policy in the first place: peace of mind. Life insurance is a serious business, much of which remains baffling to the masses. Make sure you plan ahead because you will not be able to do it when it’s too late.