Life insurance proceeds can help alleviate a major source of stress after the loss of a loved one, giving the newly bereaved time to tend to their emotional needs without fretting over their finances.
But the sudden influx of a large amount of money can also present challenging decisions. Before determining whether to save, spend, or invest those dollars, a careful review of the beneficiary’s assets and objectives is in order, said Tim Sullivan, founder and chief executive officer of Strategic Wealth Advisors Group in Shelby Township, Michigan.
“We do a complete financial analysis with our clients who receive a life insurance benefit, so we can look at their whole financial picture to determine what makes sense for them before they act on any choices available,” he said in an interview. “There are a lot of ways to use it.”
That kind of analysis can help determine not only how the money should be used, but also how the death benefit should be collected.
Generally, a life insurance death benefit can be paid out in the form of a lump sum, as an annuity, or in the form of regular installments. It is distributed to beneficiaries income tax-free, and there are no restrictions for how those proceeds are used.
First move: Wait
If you receive a life insurance payout, the best way to ensure that those proceeds get put to the most appropriate use is to delay any immediate financial decisions, said Sullivan.
“The first thing you should do is hit the pause button,” he said. “You are going through the loss of a spouse or family member, so you’re not necessarily thinking clearly. You need time to figure out what the purpose of that money should be.”
Declaring the death benefit off-limits for the first few months may also help beneficiaries resist a spending spree.
“A good number of people who get a life insurance payout have never received that amount of money before and some run out and buy a sports car or spend it foolishly,” said Sullivan. “They choose instant gratification instead of stopping to say, ‘Wait a minute. I don’t have anything set aside for retirement or my kid’s college education.’”
Taking the time to research options and gather advice from knowledgeable sources can help beneficiaries make an informed decision.
Option 1: Pay down debt
If you’re buried in debt, for example, it might make sense to take the lump-sum payout and rid yourself of high-interest credit card balances or student loans that are weighing you down, said Bryan Bibbo, a financial advisor with the JL Smith Group in Avon, Ohio.
That liberates disposable income that can be redirected to a retirement account or a savings account for short-term goals, such as a down payment for a house.
“If there is credit card debt or high-interest loans, this is the first place any life insurance proceeds should probably be used,” suggested Bibbo in an interview. “This will not only eliminate the debt, but also lessen monthly expenses.”
It’s all about return on investment, he said. Typically speaking, you can’t earn more overall money investing if you’re paying interest on a revolving credit card balance, Bibbo explained.
“There is no investment that will consistently produce 20 percent or higher returns like the credit card companies are charging,” he said.
Option 2: Create an emergency fund
A windfall of any kind is also an excellent opportunity to start or shore up your emergency fund, if you have not done so already.
A portion of your life insurance policy benefit can potentially be placed into a liquid, interest bearing account (like a savings or money market account) that can be used to cover future financial emergencies. Such savings help ensure that unexpected medical costs, home repairs, or a temporary job loss down the road will not upset your savings plan — or worse, sink your household into debt.
“Having money in a savings account is crucial for your financial well-being,” said Bibbo. “It is important to have an emergency fund with at least $10,000 to $20,000 in case your car breaks down or you need a new furnace.”
Many financial advisors and professionals recommend that working Americans have at least three to six months’ worth of living expenses set aside in an emergency fund, even more for the self-employed and those who lack income stability.
Option 3: Purchase an annuity
Some who receive a life insurance death benefit, of course, need those proceeds to help pay for monthly living expenses.
That may be particularly true for young families that need to replace the breadwinner’s paychecks or for retirees who lost a second source of household income when their spouse died and stopped collecting a Social Security check.
In those cases, it may make sense to use the life insurance policy death benefit to purchase an annuity. (Some life insurance policies may have an annuity as a settlement option.)
There are different types of annuities aimed at accomplishing different goals. Some annuities focus on providing a guaranteed income stream that begins either immediately or in the future. Others are designed to help you accumulate savings for long-term goals like retirement.
Annuities, however, are complex. If you are considering one, make sure to read any marketing material that relates to that particular annuity carefully. It is also wise to consult a financial professional who can guide you on your options.
Option 4: Collect installments
Installment payments can provide similar income guarantees to beneficiaries. Also referred to as a systematic withdrawal, the life insurance company might, for example, pay out 10 percent of the total death benefit annually over 10 years. Generally, the portion of the death benefit that has not yet been paid out continues to earn interest for the beneficiary.
But be aware that while the death benefit itself may not be subject to income tax, any interest earned by those who elect an installment payout option may be taxable.
Option 5: Invest for growth
Those who don’t need their life insurance policy benefit immediately might instead opt to take the lump-sum payout and invest it (either in part or in full) in a mix of stocks and bonds for potential growth. Here again, a financial professional can help you determine what investment mix might be most appropriate for you given your age, goals, and tolerance for risk.
If you are not fully funding your 401(k) and IRA, for example, life insurance proceeds can help supplement your savings so you can contribute a greater percentage of your earned income toward retirement.
“Using life insurance proceeds to plan for your own retirement can create a huge amount of wealth,” said Bibbo.
An investment in a diversified stock portfolio through a taxable brokerage account might also generate compounded growth over time that can help you fund long-term goals, like buying a vacation home or retiring at age 65.
A 40-year-old who invests $100,000 in a taxable brokerage account and never invests another dime could have $424,000 after 25 years, assuming a hypothetical 7 percent annual rate of return, according to the Bankrate.com return on investment calculator.
Option 6: Children’s education
Beneficiaries could also put a portion of their payout into a college fund for their children’s education. A one-time $50,000 investment in a 529 college savings plan would potentially double to $101,000 over 12 years, assuming a 6 percent annual growth rate, according to the 529 calculator on CalcXML.com.
Contributions to a 529 plan are made on an after-tax basis, but earnings and distributions are tax-free if used to pay for qualified education expenses.
“If you have extra funds from life insurance proceeds, putting that money in a 529 or UTMA account for a child will help their future,” said Bibbo. UTMA, or Uniform Gift to Minors Act, accounts are effectively custodial accounts that are used to hold assets for minors until they reach adulthood.
Option 7: A combination approach
For others, if the death benefit is large enough, a combined approach might be most appropriate.
For instance, a beneficiary could use part of a death benefit to create a guaranteed income stream through an annuity or installment plan aimed at covering living expenses for 12 to 15 years. At the same time, he or she could invest the remaining part of the death benefit in the stock market for upside potential.
In theory, that strategy would enable the beneficiary to cover short-term living expenses, while giving the invested portion of the death benefit sufficient time to generate potential returns (and ride out any Wall Street downturns). If the investment portfolio generates a reasonable rate of return over that 12 to 15 years, it could potentially help provide another decade’s worth of income.
Of course, that strategy requires the beneficiary to accept a certain level of risk in exchange for the opportunity to potentially generate higher returns.
Financial experts say beneficiaries sometimes forget that being too conservative exposes them to financial risk, too. That’s because they are denying their money an opportunity to generate adequate returns to offset a possible loss of purchasing power due to inflation. Investing exclusively in municipal bonds, for example — which are considered a low-risk, low-return investment — might not produce the kind of returns a beneficiary needs to cover their living expenses over the long term.
As with any investment strategy, it’s a good idea to seek guidance from a trusted financial professional.
Option 8: Establishing a legacy
Others who are fortunate to have saved enough to provide for their own financial needs might wish to use their life insurance proceeds to support a favorite charity or organization, instead.
This can be done through direct donations of the death benefit or by using that benefit to purchase new life insurance, which could provide control advantages.
For instance, someone could purchase a permanent life insurance policy, such as a whole life policy, and designate a charity as the beneficiary after they die. The donor would retain ownership of the permanent policy during his or her lifetime, allowing them continued access to the policy’s cash value.
Or, the policyowner could donate any dividends that particular whole life policy generates during their lifetime to the charity or charities they choose. The donor would not necessarily need to name the charity as a beneficiary of the policy.
Life insurance proceeds can solve many needs, giving beneficiaries the resources required to put their financial house in order after the loss of a loved one.
To determine how best to put those dollars to work, however, it’s important to seek guidance from a professional and to consider your financial goals.
Provided by Shelley Gigante, courtesy of Massachusetts Mutual Life Insurance Company (MassMutual).
©2020 Massachusetts Mutual Life Insurance Company, Springfield, MA 01111-0001 CRN202109-254065