Life insurance protects against financial losses from a person's death. If someone is covered by one of these policies, the insurer agrees to pay their heirs a cash death benefit when they pass away. While life insurance may be a seemingly straightforward arrangement, there are some rules and potential trouble spots to watch out for. Here's what you should know about how life insurance payouts work so you and your family can prepare.

How Do Life Insurance Payouts Work?

When you sign up for life insurance, you pick how much coverage you want for the death benefit, like $50,000 or $250,000. You then agree to pay insurance premiums to keep your coverage active. The larger the payout, the more expensive the policy will be.

Then, if you die while covered by the policy, the life insurance company will pay your heirs the policy death benefit. You pick who you want to receive the money. This person is known as your beneficiary. You can also pick multiple beneficiaries to divide the payout, for example, if you wanted to split the payment 50/50 between your two children.

What Does Life Insurance Cover for Payouts?

Life insurance covers most causes of death, including illness, accidents or old age. There are a few exceptions when the policy might not pay, such as if the death is caused during or because of an illegal activity like a robbery. Life insurance also does not cover death by suicide if it happens within two years of someone buying a policy. Life insurance may also not cover death from dangerous hobbies like auto racing or scuba diving.

A policy might deny payment if a person lied on their application, such as by hiding an illness, and they then die from that hidden issue within two years of buying the policy, known as the contestability period. A life insurance policy should list the exclusions for payouts in the contract.

How Do You File a Claim for Payment?

If someone dies and named you the beneficiary for their life insurance, you would file a claim with their life insurance company to collect payment. If you know the deceased had been working with a specific life insurance agent, you can contact that professional. Otherwise, you could call the life insurance company's customer service line.

Let them know that the deceased passed away and that you are the beneficiary of their life insurance. You will need to fill out a short form listing your name, address, contact information and relationship to the deceased. You should also list the deceased's personal information and cause of death. Last, you will need to submit a certified copy of their death certificate.

How Long Does It Take To Receive a Payout?

Once you submit your claim for the life insurance payout, the life insurance company will review all the information. They will confirm that you are the beneficiary of the policy. They will also review the details of the person's death to make sure it wasn't from an excluded cause, especially if they died within two years of buying the policy and it's still within the contestability period.

This review process usually takes less than a month. If the insurer suspects a problem, like the applicant hid an illness, it could take longer as they investigate the claim. Assuming all the details of the claim work out properly, the life insurance company will then send you the life insurance payout.

How Can You Receive the Life Insurance Payout?

There are a few ways you can receive the life insurance payout. The simplest and most common is to receive everything as a lump sum payment. With a lump sum payment, the insurer would send you a check or deposit the money in your bank account.

You can also choose to split the payment out over installments paid over a set schedule. You might prefer this option for budgeting purposes. The insurer may allow you to split the death benefit into income payments for life. If you can't do this but it's something you're interested in, you could use the life insurance payout to buy an annuity (a type of insurance contract that can make guaranteed payments for life).

Last, if you need time to decide what to do with the money, you can ask the insurance company to hold the payment and just pay you interest on the balance. Once you're ready to decide what to do with the funds, you can collect payment.

Will You Owe Taxes on Life Insurance Payouts?

The government does not charge income tax on life insurance payouts for death benefits. However, it is possible to owe estate taxes on these payments. When a person dies, the entire value of their final net worth is their total estate, which they then leave to their heirs. Any life insurance death benefit is also added to the size of their estate, so a $1 million policy would increase their estate by $1 million.

In 2023, someone can leave an estate up to $12.92 million to their heirs without owing federal estate taxes. After that, the IRS charges estate taxes. It's only if someone is over the limit that their life insurance payout could be taxed. Since the federal limit is so high, it won't apply to most people.

17 states and Washington D.C. also charge estate and/or inheritance taxes for transferring property at death. Their limits may be lower than the federal level. For example, Oregon starts charging taxes on estates worth over $1 million.

What Problems Could Get in the Way of Payment?

If the policyholder stopped paying their life insurance premiums, they may have lost their coverage. In that case, you wouldn't receive the life insurance payout after they die.

Another issue could come up if the policyholder didn't list a beneficiary or if the beneficiary they listed has already died. In that case, the life insurance company would pay the money directly to their final estate, and it would go through probate — a legal process where a state court reviews a person's will and distributes their property according to those instructions.

The life insurance payout would then follow the rules of the will. The probate process takes time, which can delay how long you get paid versus if you had been listed as the beneficiary.

Last, you might struggle to get paid if you don't have the information about the deceased's policy, like the policy number, or if you don't know what company they were working with.

How Can You Find Out if You're Owed Life Insurance Payouts?

If someone died and you think they had life insurance, but you aren't sure of the details, you will need to do some searching. Go through their financial records to see if you can find the policy itself as well as any bills, letters, or other communication from a life insurance company. If your loved one worked with a financial advisor, accountant or other professional, you could ask if they know anything.

Besides that, you can try running a search through the National Association of Insurance Underwriters (NAIC). They have a free online tool that searches the databases of insurance companies to see whether there's a policy for your loved one.

Still, you could avoid having to go through this search by getting any insurance information from your loved one before they pass away. Make sure to discuss life insurance details and financial plans with your loved ones so everything goes smoothly with future payouts.