Laura Berry is a former State Farm insurance producer and insurance expert.

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Dan Walker graduated with a BS in Administrative Management in 2005 and has been working in his family’s insurance agency, FCI Agency, for 15 years. He is licensed as an agent to write property and casualty insurance, including home, auto, umbrella, and dwelling fire insurance. He’s also been featured on sites like Reviews.com.

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Reviewed by Daniel Walker
Licensed Car Insurance Agent

UPDATED: Mar 2, 2017

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Don't miss these facts...

  • Life insurance proceeds may be paid to the beneficiary of the policy at the death of the insured in cans or in installment payments
  • The payments can be arranged in a variety of different amounts and time periods, but part of the payments will constitute interest, and that interest will be taxable as ordinary income
  • The income option that can be chosen by the beneficiary is called the choosing of settlement options to pay out the death benefit proceeds
  • The income payments can be in the form of a life annuity, a life annuity with periods of years of payment certainty, or an interest option, with the beneficiary having full control
  • There are other arrangements that can cause taxes to be paid with life insurance policies such as improper transfers for value and estate taxes


A life insurance policy does have the capability to be turned into an annuity. If the life insurance results in the payment of a death claim, the beneficiary may elect to take the proceeds as an annuity, or a periodic payout.

If the insured lives to retirement age, the cash values of the life insurance can be paid to the insured as a retirement income, or as an annuity.

A life annuity is an arrangement where a lump sum of money is paid out to a person over the rest of his or her lifetime, no matter how long he lives. Only a life insurance company can do this, by law.

Using annuity tables, the life insurance company will configure a monthly amount of income that will pay to the insured, who is now called the annuitant, for the rest of his or her life or the number of years desired, if different than a life income.

If an income option is chosen at the death of an insured the process is called the election of the settlement options of the policy. However, it is one in the same as an income annuity.

Life insurance death benefits are received income-tax-free as described in IRS Code 7702 if they are received as a lump sum.

That means if a beneficiary receives a lump-sum cash payment of $100,000, the amount of the life insurance death benefit, there will be no federal income tax payable on that amount of benefit.

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Receiving an Income

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It is possible for a beneficiary to receive income from the death proceeds of a life insurance policy. This is known as receiving “settlement options” or annualizing the proceeds.

If a person decides to receive the death benefit proceeds in this way, there will be some income tax to pay.

The reason for this is because the payout amounts that come to the annuitant are made up partially of principal and partially of interest.

If the money is annuitized, then part of the income will be allocated as interest and part of the income will be allocated to principal.

For lack of a better term, this is called the “annuity rule.” An exclusion ratio is determined by the insurance company that is paying out the annuity.

The exclusion ratio determines just how much each year in income taxes by allocating how much is principal and how much

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There Are Choices When it Comes To Taking Income From Life Insurance Proceeds

Life insurance settlement options have a number of different ways that a beneficiary can receive income.

Depending upon the amount of life insurance that the insured individual had in force, a very creative and solid stream of income can be devised to meet the needs of a family.

There are guarantees, flexibilities, and safeguards built into the framework of the settlement options.

These settlement options are essentially the same thing as annuities, the only difference being settlement options are derived from life insurance death proceeds and annuities come from any other form of cash.

Beneficiaries Choosing Settlement Options – Life Annuity

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A life annuity is a monthly income that will last as long as the annuitant who is receiving the annuity payments lasts. If the annuity dies at any time during the payout.

If the annuitant dies before enough money is paid to equal the original death proceeds amount, that money would be lost.

This option pays the highest income but is risky unless there are no other heirs and the beneficiary needs as much income as possible.

Beneficiaries Choosing Settlement Options – Life Income Annuity with Period Certain

A life income with a period certain option puts more security in the settle options. With this choice, the income is paid for life with an amount of certain time which guarantees the money for a set period of time, whether the annuitant lives or dies:

  • Life Income 5 Years Certain – Income is paid for the life of the annuitant but is guaranteed for 5 years.
  • Life Income 10 Years Certain – Income is paid for the life of the annuitant but is guaranteed for 10 years.
  • Life Income 15 Years Certain – Income is paid for the life of the annuitant but is guaranteed for 15 years.
  • Life Income 20 Years Certain – Income is paid for the life of the annuitant but is guaranteed for 20 years.
  • Life Income With Refund Certain – With this option, a life income is paid to the annuitant and if the annuitant dies any balance of the original death benefit will be refunded to the annuitant’s beneficiary.
  • The Interest Option – The life insurance proceeds are held with the company at interest, usually with full right of withdrawal and access to all other options at the discretion of the beneficiary.

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Other Taxable Events that can Occur

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If an improper transfer for value is made, a taxable situation can occur.

A transfer for value occurs when a life insurance policy is transferred to someone or to an entity of some sort and there is an exchange for another item of value, the death benefit can be includible in the gross income of the beneficiary.

There are rules to be followed and if they are violated, then the proceeds can be taxable as ordinary income.

An example of a violation of a transfer for value transaction could occur if a life insurance policy were to be exchanged for a piece of real estate, and the value of the real estate was worth more than the death benefit of the life insurance policy.

If an insured dies and is the owner of the life insurance policy, the proceeds of the policy would be included in the insured’s gross estate for estate tax purposes.

The estate would have to be quite large under current law, which excludes the first $10 million in an estate where a husband and a wife are involved.

In Conclusion

Beneficiaries of life insurance proceeds can take the death benefit in the form of an income. This is called the utilization of the settlement options of the life insurance policy.

There is an interest portion of the income that will be taxed as ordinary income.

Life policies that are used in transfer for value transactions run the risk of having the death benefit taxed as ordinary income. Life insurance proceeds can also be taxes in the estate tax realm.

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