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How to protect life insurance beneficiaries from a windfall

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Clients who wish to exercise control over how or when their beneficiaries receive assets may be wary of life insurance policies that typically allow the policy beneficiaries to control the method under which death proceeds are distributed. While the usual life insurance policy allows the policy death proceeds to be distributed in a variety of manners, the beneficiary is given the choice of how and when to receive them, regardless of whether this decision is in accord with the policy owner’s wishes. A new trend in product offerings may serve to reverse the course of this eventuality by allowing the policy owner to protect the beneficiaries while generating potentially substantial additional benefits under the policy in the process.

Beneficiary-directed payment of death proceeds

By default, most life insurance policies pay out death proceeds to the policy beneficiary or beneficiaries in one tax-free lump sum distribution. While this is typical, the policy beneficiary usually has the option of receiving the proceeds in installments, whether over a fixed period of time or using a fixed amount that is paid out until the proceeds are depleted.

The death proceeds of a life insurance policy are usually received tax free by the policy beneficiary, but any interest earned on the proceeds is taxable to the beneficiary upon receipt. Therefore, if the beneficiary chooses to receive the proceeds in installments, he will be responsible for paying taxes on the interest earned while the funds remain with the insurance company. The practical result of this is that most policy beneficiaries will choose to receive the proceeds as a lump sum, whether or not it is in their best interest to do so.

Owner-directed payment of death proceeds

It is common for clients to be wary of leaving their children-beneficiaries with large lump sum cash payments upon their death. They may be worried these beneficiaries will be unable to successfully manage a windfall inheritance or that they will quickly spend down the assets and be left without sufficient funds. Many clients may simply wish to ensure their children have the motivation to cultivate a strong work ethic before they come into a large inheritance.

Insurance companies today have begun to realize that policy owners often wish to direct the distribution of death proceeds payable under insurance policies on their own lives. As a result, these companies are offering policies that allow the policy owner — at the time of purchase — to specify how and when the beneficiary will receive the death proceeds. These policies can allow the owner to have the proceeds distributed evenly over a period of time or in a combination of even installments with larger lump sum payouts disbursed at certain intervals.

See also: Keeping universal life products attractive

By initially dictating how beneficiaries will receive the policy proceeds, the owner can ensure beneficiaries are provided for in the long term, whether or not these beneficiaries would be capable of making financially sound investment decisions.

Further, because the policy proceeds will be stretched over a longer period of time, the risk to the insurance company is reduced. It will no longer be liable for paying a large lump sum at the policy holder’s death. This factor reduces the cost of these life insurance policies in some cases and can allow the owner to invest greater amounts in the policy, potentially resulting in a faster-growing cash value.

It is important the client realizes the beneficiaries will be liable for taxes on the interest earned over the period of time that the proceeds are controlled by the life insurance company. It is also important to advise clients that the distribution decision is often irrevocable.


While not all owners of life insurance policies want to require their beneficiaries to receive death proceeds over a period of time because of the associated tax liability, owner-directed distribution of proceeds may be appealing to clients who have resisted purchasing life insurance for fear of creating a financial windfall for beneficiaries. These policies can give prospective purchasers exactly what they have been looking for: control over exactly how and when their life insurance assets are distributed after death.

For more on estate planning, see:

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