What are Policy Proceeds?
In life insurance, the policy proceeds are the sums paid out to the beneficiaries when the insured dies.
How policy proceeds get calculated
When you buy life insurance, you choose a specific death benefit, also called the policy’s face value. This is the amount of money that will go to your beneficiaries when you pass away.
That said, the actual policy proceeds your beneficiaries receive might differ from the face value you purchased. This applies when you use certain riders on your coverage or use your policy’s cash value in specific ways.
If you had a long-term care rider on your policy and activated it, for example, the amount of money you take toward your long-term care will get subtracted from your death benefit. Similarly, if you took out a policy loan and have an outstanding balance when you pass away, your life insurance company will take money from your death benefit to repay the loan.
In other words, you can do things while you’re alive that impact the policy proceeds your beneficiaries get when you die.
How policy proceeds get distributed
When you pass away, the policy proceeds get divvied up per the wishes you specified in your policy terms. If you named two beneficiaries with equal shares, for example, they’ll split the policy proceeds between them. Or if you named a minor as your beneficiary and established a trust for them, the policy proceeds go into that trust.
Unless you specified how the money should get paid (e.g., that you wanted the lump sum paid into a trust), your beneficiaries may have options about how they receive the policy proceeds.
While many people choose to take that money as a lump-sum payment, others opt to establish a structured payment plan, like an annuity. In these cases, the money goes into an interest-earning account. Then, the beneficiary gets regular distributions from the account, plus interest earnings, on a set schedule over a predetermined time period.
Taxation on policy proceeds
The IRS doesn’t require you to include policy proceeds from life insurance in your gross income, which means they aren’t subject to taxation.
That said, if you set up a payment plan and the money goes into an interest-earning account, the interest you earn can be taxed as income. It can be helpful to consult with a tax professional when establishing an annuity or another payment structure to ensure you understand the tax implications.