Life insurance is a valuable financial tool that can be used to provide financial security and peace of mind for your loved ones when you pass away. 

One of the advantages of life insurance is its potential to serve as an inheritance for your beneficiaries.

In this blog post, we will explore how life insurance can be used as an inheritance, how the payout works, and the benefits of using life insurance as an inheritance.

This article is written as general education, and should not be considered as personal financial advice. If you would like personal guidance with life insurance, you can schedule a time to talk with one of our experts.

Can You Use a Life Insurance Death Benefit for an Inheritance?

Yes, you can use a life insurance death benefit as an inheritance for your beneficiaries. Life insurance policies are designed to provide a death benefit to the beneficiaries upon the insured's death. 

This payout can be used by the beneficiaries for any purpose, including as an inheritance. 

If you would like to control the payout, meet with your estate planning attorney to discuss setting up a trust that would ensure the funds are used as you see fit.

How Does a Life Insurance Death Benefit Claim Payout Work?

When you purchase a life insurance policy, you name one or more beneficiaries who will receive the death benefit upon your passing.

The beneficiaries can be individuals, a trust, or even a charity. 

The death benefit is the amount of money the insurance company pays to your beneficiaries when you die. 

The amount of the death benefit is determined by the amount you wish/qualify for to purchase and can range from thousands to millions of dollars. 

Keep in mind that no insurance company will allow you to purchase an amount of life insurance that would be considered “excessive” in relation to your financial situation/net worth because no one should be “profiting” from your death.

Upon your death, your beneficiaries will need to file a claim with the insurance company, providing a copy of the certified death certificate and other required documentation such as personal information of the deceased, the life insurance policy number, or other requested items.

If you are not sure about policy information there is a database that the National Association of Insurance Commissioners (NAIC) has set up to assist you in finding life insurance and annuity contracts of deceased loved ones, which you can find through this link.  

The claims process may take days to months. Complications like death in the early years of the policy, unusual circumstances, death in a foreign country, or suspicions of fraud will all increase the claim time. 

Interest is paid on the death benefit during the processing of the claim and is taxable.

Once the claim is approved, the insurance company provides options to the beneficiaries on how they would like the insurance to payout, provided they are not a trust. 

Options for death benefit claim payout:

Interest bearing account

Generally the default option if no selection is made, the monies would be placed in an account at the insurance company that earns interest. 

The beneficiary receives a checkbook/card and can spend money as they would like. 

Interest earned in this account is taxable. 

The owner of the account can name a beneficiary.

Check 

A check in the amount of the death benefit and any interest earned sent directly to the beneficiary. 

Interest earned during the processing of the claim is taxable. 

Note that US banks may hold a portion of large checks for a period of time before providing liquid cash.

Annuity for a period certain

The beneficiary chooses a period of time (e.g. 20 years) in which to have the death benefit payments paid over. 

There will typically be interest accruing this time, which is taxable. 

These payments are guaranteed, and the recipient can list a beneficiary. 

Annuity for life 

The death benefit payments are made over the lifetime of the recipient. 

There will typically be interest accruing this time, which is taxable. 

These payments are guaranteed and the recipient can list a beneficiary.  

What Are the Benefits of Using Life Insurance as an Inheritance?

1. The Payout Is Received Directly by the Beneficiaries

One of the main benefits of using life insurance as an inheritance is that the death benefit is paid directly to the named beneficiaries, bypassing the probate process. 

Probate is the legal process of administering a deceased person's estate, which can be time-consuming and costly. 

By receiving the death benefit directly, your named beneficiaries can avoid the probate process and gain access to the funds more quickly.

2. Beneficiaries Can Use the Payout for Any Purpose

Unlike other forms of inheritance, such as real estate or stocks, life insurance payouts are not restricted in how they can be used. 

Therefore, your beneficiaries can use the payout for any purpose they see fit, whether it's paying off debt, covering living expenses, funding education, or investing in their future. 

This flexibility can be particularly beneficial in times of financial stress or uncertainty.

If you would like to control the payout of the death benefit, talk with your estate planning attorney about setting up a trust.

3. The Death Benefit Payout Tax Advantages

Another significant advantage of using life insurance as an inheritance is that the death benefit payout is generally free from ordinary federal income tax if you have a properly structured ownership and beneficiary arrangement. 

This means your beneficiaries will not have to pay federal income tax on death benefit, but they will owe taxes on any interest earned. 

Be aware that if you own your own policy, or your spouse's policy, the death benefit will be included in your overall estate for estate tax purposes. 

It is particularly important to understand that if your estate is over the federal or state estate tax limit, the excess amount is taxable. 

The federal and state estate tax thresholds are subject to change but the 2023 IRS threshold is $12,920,000 and is set to sunset at the end of 2025. 

Proper ownership and beneficiary arrangement are one of the biggest mistakes that people make on their life insurance, often causing the death benefit to become taxable. 

There are 3 people/entities that can be listed on a policy, but if you have more than 2 names on any of three options, it will cause your policy to become taxable. 

Owner- The person/entity who signs the contract and typically pays premiums.

Insured- The person whose life is being covered by the life insurance policy.

Beneficiary- The person/entity who would receive the death benefit when the insured dies.  

An example of a taxable ownership/beneficiary arrangement would be:

Owner- Jane’s Fake Business, LLC

Insured- Jane Doe

Beneficiary- George Doe  

Additionally if the policy has Estate of the insured listed as the beneficiary, it would be subject to probate, and is possibly taxable. 

If no one is listed as the beneficiary or your beneficiary passes away and there is no secondary or tertiary beneficiary named, then your policy would revert back to the insured’s estate. 

An Individual Life Insurance Trust (ILIT) listed as the owner and beneficiary would provide that the death benefit is not considered part of your estate for estate tax purposes. Be sure to consult your tax advisor and estate planning attorney for more information. 

Final Thoughts

Using life insurance as an inheritance is a smart financial planning strategy that can provide numerous benefits for your loved ones. 

By purchasing a life insurance policy, you can ensure that your named beneficiaries receive a tax-advantaged, flexible financial resource that can be used for any purpose when you pass away. 

Alternatively, you can set up a trust and control the use of the funds from beyond the grave.

If you are looking to get a life insurance policy, let our team at White Swan help you. 

White Swan is a digital broker that provides access to the universe of life insurance solutions, and can help you build tax-advantaged wealth and keep your loved ones or business protected.

Our streamlined platform makes it simple, transparent, and quick to get the optimal policy for your needs and circumstances, straight from one of America’s top carriers.

To get started you can request a personal plan online or schedule a call with one of our industry experts.