Life insurance settlement options: lump sum, installments or lifetime income

Life insurance settlement options are the ways an insurer can pay out a death benefit: a single lump sum, interest only with the principal left on deposit, fixed installments over a set period, fixed amounts until the money runs out, or a guaranteed income for the beneficiary's life. The death benefit itself is generally free of federal income tax, but any interest the insurer adds while it holds the money is taxable. Choosing between the options is really a choice about who holds the money, for how long, and at what rate.

I cover this topic alongside structured settlements because the mechanics are closely related. In both cases, a lump sum that is owed to someone is turned into a series of payments by an insurer, and the recipient has to decide whether a guaranteed stream is worth more to them than cash in hand.

Who chooses the settlement option

Either the policy owner or the beneficiary can choose, depending on timing and the policy wording.

• The policy owner can often elect a settlement option in advance. This is sometimes done when the beneficiary is young, has a disability, or is not expected to manage a large sum well. Where the owner has made the election, the beneficiary may not be able to change it.
• The beneficiary chooses at the time of the claim if no advance election was made. This is the more common situation.

The options available are set by the policy and by the insurer's current practice. Not every insurer offers every option, and some offer extra ones. The claim form or a call to the claims department will tell you what is actually available.

The main settlement options

Option	How it works	Who holds the principal	Can you access principal later?
Lump sum	Full death benefit paid at once, by check or electronic transfer	You	Yes, it is yours
Retained asset account	Benefit placed in an account at the insurer; you write drafts against it	Insurer	Yes, usually at any time
Interest only	Insurer holds the benefit and pays you interest; principal paid later	Insurer	Depends on the terms elected
Fixed period	Benefit plus interest paid in equal installments over a chosen number of years	Insurer	Usually not
Fixed amount	A set payment each period until the benefit and interest are used up	Insurer	Sometimes, depending on terms
Life income	Payments for the beneficiary's lifetime, sometimes with a guarantee period or refund	Insurer	No

Lump sum

The lump sum is the default and the simplest option. You receive the full death benefit, generally free of federal income tax, and you decide what to do with it. The money can go into a bank account, pay off debts, be invested, or be used to buy an annuity later if you decide you want income.

The practical advantage is flexibility. The disadvantage is that you have to manage it yourself, and a large sum arriving during a period of grief is often when people make decisions they later regret.

Retained asset account

Many insurers pay claims above a certain size into a retained asset account unless the beneficiary asks otherwise. You receive something that looks like a checkbook. The insurer keeps the money in its general account, credits interest, and pays out whenever you write a draft.

Two things to understand about these accounts:

• They are not bank accounts. The money is an obligation of the insurance company, not a deposit at a bank, so it is generally not covered by FDIC insurance. Protection if the insurer fails comes from your state guaranty association, within its limits and subject to state law.
• The interest rate may be low. Insurers set the credited rate. Compare it with what you could earn elsewhere before leaving money there for a long time.

A retained asset account can be a reasonable parking place while you decide what to do. It is not usually designed to be a long-term home for the money.

Interest only

Under the interest-only option, the insurer holds the full benefit and pays you the interest it credits, monthly or annually. The principal is paid out later, either on request, at a date you set, or to a secondary beneficiary at your death.

This keeps the principal intact and defers the decision about what to do with it. The interest you receive is taxable income each year.

Fixed period

With a fixed period option, you choose a number of years and the insurer pays the benefit plus interest in equal installments over that period. If you die before the period ends, the remaining installments go to a contingent beneficiary.

This works like a period certain annuity without the life element. It suits someone who needs income for a defined stretch, for example until a child finishes school or until pension income starts.

Fixed amount

The fixed amount option reverses the fixed period option. You choose the payment size, and the insurer pays that amount until the benefit and accrued interest are exhausted. A higher payment runs out sooner; a lower one lasts longer.

Life income

The life income option converts the death benefit into an annuity on the beneficiary's life. Variations mirror those on a standard annuity: life only, life with a period certain, life with a refund, or joint life with another person. Payments are guaranteed for life, but once elected the choice generally cannot be undone and the principal is no longer available.

The payment rate depends on the beneficiary's age and the insurer's settlement option rates. Some older policies contain guaranteed settlement option rates written into the contract, which can occasionally be better than what the insurer offers on a new annuity today. It is worth asking.

How each option is taxed

The core rule comes from IRC §101(a) and is explained in IRS Publication 525: life insurance proceeds paid because of the insured person's death are generally excluded from the beneficiary's gross income. The complications come from interest.

• Lump sum. Generally not taxable. If the insurer pays interest for the time between the death and the payment date, that interest is taxable.
• Retained asset account and interest only. The principal remains excludable. The interest credited or paid is taxable as interest income, and the insurer will usually report it on a Form 1099-INT.
• Installments (fixed period, fixed amount or life income). Under IRC §101(d), the amount that would have been paid as a lump sum is spread across the payments as a tax-free portion. The rest of each payment is interest and is taxable. The insurer normally tells you the split each year.

There are exceptions to the general exclusion, most notably where a policy was transferred for value during the insured's lifetime, and some employer-owned policies. Estate tax is a separate question: the death benefit can be included in the insured person's estate for estate tax purposes even when it is free of income tax to the beneficiary. Verify your own position with the IRS publications or a tax adviser before acting.

An illustrative comparison

The numbers below are invented to show how the options differ in shape. They are not quotes. Real figures depend on the insurer's credited rates and settlement option tables on the date of the claim. Rates change; verify before acting.

Assume a 60-year-old beneficiary is owed a $300,000 death benefit and is offered:

• Lump sum: $300,000 now, generally tax-free
• Interest only at an assumed 3% credited rate: about $9,000 a year in taxable interest, principal intact
• Fixed period of 10 years at an assumed 3%: about $2,897 a month for 120 months, roughly $347,600 in total, of which $300,000 is tax-free and the balance is taxable interest
• Life income: a monthly amount from the insurer's settlement table, paid for life

The fixed period looks like it pays more than the lump sum, and in nominal terms it does. But the extra $47,600 or so is simply interest at the assumed 3% on money the insurer holds. The fair comparison is whether you could earn more than that, after tax and after considering risk, by taking the lump sum and investing it or buying an annuity on the open market. The same present-value reasoning applies to any choice between a lump sum and a payment stream, which I explain in structured settlement vs lump sum.

How settlement options compare with a structured settlement

The parallels are close, but the legal differences matter.

• Tax basis. A personal injury structured settlement relies on IRC §104(a)(2) and the qualified assignment rules. Life insurance relies on IRC §101. Both exclude the principal, but they handle growth differently. In a qualified structured settlement, the full periodic payments for physical injury are generally tax-free, including the growth built into them. With a life insurance installment option, the interest element is taxable.
• Selling the payments. Structured settlement payments can only be sold through the court approval process set out in state Structured Settlement Protection Acts, with IRC §5891 imposing an excise tax on transfers that skip it. Life insurance installment payments are governed by the policy and state insurance law, and some contracts restrict assignment altogether.
• Flexibility at the start. A structured settlement is usually negotiated as part of the case settlement and cannot be changed afterwards. A life insurance beneficiary usually has a free choice at the time of the claim, unless the owner locked in an option in advance.

If you already receive a structured settlement and are now also a life insurance beneficiary, the decision about the death benefit is independent. See our structured settlement payout options guide for how settlement streams are typically designed.

What to check before choosing

1. List every option the insurer offers, and ask for figures for each in writing.
2. Ask about guaranteed settlement rates in older policies. Some pre-date current pricing.
3. Compare credited interest rates on retained asset and interest-only options with alternatives you could use yourself.
4. Check the insurer's financial strength and your state guaranty association's coverage if a large amount will stay with the insurer for years.
5. Consider who inherits the remainder. Name a contingent beneficiary for any unpaid installments.
6. Do not rush. In most cases you can leave the money in a retained asset account or take a lump sum and decide later. An irrevocable life income election cannot be reversed.

If you are also looking at the other side of the market, where a policy owner sells a policy before death, our explanation of a viatical settlement covers how that works.

Frequently asked questions

Is a life insurance payout taxable if I take installments?

The part of each installment that represents the original death benefit is generally tax-free. The interest the insurer adds is taxable. The insurer should report the taxable part to you each year.

Can I change my settlement option after I choose it?

Lump sum, retained asset and some interest-only arrangements can usually be changed or withdrawn. Fixed period and life income options are generally irrevocable once payments begin. Ask the insurer before you sign.

Is a retained asset account FDIC insured?

Generally no. The balance is held by the insurance company, not a bank. Coverage if the insurer fails comes from the state guaranty association system, subject to limits that vary by state.

Should I take a lump sum or an income option?

That depends on your need for income, your other assets, your health and how comfortable you are managing a large sum. Compare the income option against what the lump sum could buy or earn elsewhere, and speak to a fee-only adviser if the amount is significant.

This article is general education, not personal financial, tax or legal advice. Policy terms and tax rules vary and change, so confirm the details with the insurer and a qualified professional before acting.