What is a death benefit?
– Definition: A death benefit is the cash payment (lump sum or series of payments) that a contract—most commonly a life insurance policy, an annuity, or a pension—pays to a designated beneficiary when the insured or annuitant dies.
– Key utility: It’s designed to provide financial support for survivors (funeral costs, debts, living expenses) after the contract holder dies.
Common terms (defined on first use)
– Beneficiary: the person or entity named to receive the death benefit.
– Premium: regular payment the policyholder makes to keep an insurance policy active.
– Annuity: a contract that typically pays income over time; some annuities include a death benefit for remaining value.
– Probate: the legal process of settling someone’s estate and validating a will; passing proceeds through probate can delay payment.
– Retained asset account: a program where the insurer holds the proceeds and pays interest; the company acts like a bank for the beneficiary.
Types of death benefits
– Life insurance death benefit: set in the policy contract and chosen by the policyholder; often paid as a lump sum.
– Accidental death benefit (ADB): an add-on that pays extra if death is due to an accident.
– Accidental death and dismemberment (AD&D): covers accidental death and certain severe injuries.
– Annuity/pension death benefit: may pay remaining contract value or continuing payments to a named beneficiary; tax treatment differs from life insurance.
How payments can be made
– Lump sum: single full payout of the death benefit (most common for life insurance).
– Installments: fixed periodic payments until funds are exhausted or for a set period.
– Life-contingent annuity: insurer pays installments for the beneficiary’s life.
– Retained asset account: insurer holds proceeds and pays interest; beneficiary withdraws as needed.
Practical checklist: What beneficiaries should do
1. Confirm the insurer and policy/contract:
– Ask the deceased (if possible), check paperwork, check safety-deposit boxes, contact employer HR for group plans.
– Use a policy-locator service if you cannot find information.
2. Gather documentation:
– Certified death certificate (insurers normally require an official copy).
– Policy or contract number(s), the deceased’s Social Security number, and personal ID for the claimant.
3. Complete claim forms:
– Submit the insurer’s death-claim form and any required attachments.
– If multiple beneficiaries are named, each may need to complete forms.
4. Select payment option:
– Decide between lump sum, installments, annuity payout, or retained asset account per the contract.
5. Keep records:
– Save copies of all forms, correspondence, and proof of filing.
6. Consult professionals:
– Talk to a tax advisor or estate attorney before choosing how to receive proceeds if taxes or estate issues may apply.
Tax and estate implications (what matters)
– Life insurance death benefits:
– Generally not included in the beneficiary’s ordinary income (i.e., not income-taxable) when paid as a lump sum.
– If the proceeds are left with the insurer and earn interest, the interest portion is taxable as ordinary income.
– If no beneficiary is named and the proceeds go to the decedent’s estate, they may be included in the estate for estate-tax purposes if the estate exceeds applicable exemption thresholds.
– Annuities and pensions:
– Proceeds often have a taxable component because part of payments represent earnings (investment gain) rather than return of principal. Beneficiaries typically must report that taxable portion as income.
– Rules vary by contract type and whether the annuity already produced taxable income to the decedent.
– State rules and exceptions can differ; consult a tax professional.
Small worked numeric example
Scenario: A life insurance death benefit of $250,000 is paid into an insurer’s retained asset account that pays 2% annual interest. The beneficiary leaves the principal untouched for one year and receives only the interest.
– Principal (tax-free portion):
$250,000
Interest earned for one year at 2%:
– Calculation: 250,000 × 0.02 = 5,000
– Interest received by beneficiary (taxable): $5,000
Tax effect (worked numeric example)
1. Interest taxed as ordinary income. If the beneficiary is in the 22% federal marginal tax bracket:
– Federal tax on interest: 5,000 × 0.22 = $1,100
– After-tax interest received: 5,000 − 1,100 = $3,900
2. State income tax may also apply; multiply taxable interest by your state rate to estimate additional tax.
3. Reporting: the insurer typically issues Form 1099-INT for interest of $10 or more; the beneficiary reports the interest on their federal income tax return.
Notes and assumptions
– Assumes the full death benefit principal ($250,000) is a true life insurance death benefit and therefore not includable in the beneficiary’s gross income as ordinary income. (Different rules can apply for transfers for value or if the contract had other taxable features.)
– Assumes the insurer placed proceeds in a retained asset account (an account the insurer uses to hold proceeds and credit interest) that pays 2% and the beneficiary received only interest during the year.
– Does not consider estate-tax inclusion. If the decedent retained certain ownership rights in the policy, the proceeds may be includible in the decedent’s estate for estate-tax purposes; estate tax rules and exemption amounts change over time.
Practical checklist for beneficiaries
– Confirm how proceeds will be delivered (lump sum, retained asset account, installments).
– Ask whether interest will be paid or left to accumulate; get the interest rate in writing.
– Expect a Form 1099-INT if interest ≥ $10; verify the amount before filing taxes.
– Estimate federal and state tax on interest using your marginal rates.
– Keep records: death certificate, policy/claim paperwork, and any communications about payouts.
– Consult a tax professional if the estate is large, the policy was owned by the decedent at death, or if proceeds were used to purchase an annuity or other investment.
Quick decision example (illustrative only)
– If you want liquidity and simplicity: accept a lump sum and invest elsewhere, understanding interest earned outside the policy will be taxable as usual.
– If you prefer guaranteed interest and automatic check-writing: retained asset accounts offer convenience but may pay a lower rate than market alternatives; interest is taxable.
References
– Investopedia — Death Benefit: https://www.investopedia.com/terms/d/deathbenefit.asp
– IRS Publication 525, Taxable and Nontaxable Income: https://www.irs.gov/publications/p525
– IRS — About Form 1099-INT, Interest Income: https://www.irs.gov/forms-pubs/about-form-1099-int
– National Association of Insurance Commissioners (NAIC) — Retained Asset Accounts: https://content.naic.org/consumer_retained_asset_accounts.htm
Educational disclaimer
This explanation is educational only and not individualized tax or investment advice. Consult a qualified tax professional or attorney for guidance specific to your situation.