Life insurance is a contract by which an insurance company agrees to pay a sum of cash or stream of payments in the event of the death of an insured person. Because people suffer severe economic hardships in the event of the death of a loved one or close business associate, life insurance is a key part of financial planning. Widows and orphans are assured of food on the table and a roof over their heads in the event of a family member's death, while businesses that would otherwise have to be liquidated following the death of a partner or key employee can remain open, working off the cash death benefit.
Typically, a life insurance company will pay a death benefit to a beneficiary within a few days of receiving proof that the insured has died. Most commonly, the beneficiary or policy owner goes to the office of the county or state coroner and obtains a death certificate. He then provides the death certificate to the insurance company or agent, and fills out a form. Death benefits are normally paid out free of income tax, though interest on the death benefit is still taxable as income.
Ordinarily, an insurance company can pay a death benefit within a few days of receiving satisfactory proof of the death of the insured. However, insurance companies can and occasionally do contest the paying of a death benefit when they suspect misrepresentation, suicide or fraud. By law, the contestability period for life insurance policies is two years. During that two-year period, the insurance company has broad latitude to question or dispute insurance claims. This could substantially delay the payout. After two years from the death, the law sharply limits the ability of insurance companies to dispute death claims.
If the beneficiary or beneficiaries are under age 18 at the time of the claim, the insurance company cannot pay the claim. However, they may pay the money into a trust for the child's benefit, or into a Uniform Transfer to Minors Act or Uniform Gift to Minor's Act. The policy owner would appoint a guardian to direct the usage of money. If a guardian trustee is duly appointed, the insurance company can pay the benefit right away. If not, the insurance company will have to defer payment until the beneficiary or beneficiaries reach the age of majority.
When you take a death benefit from an insurance company, you can select from a number of payout options. You can take a lump sum, which is normally tax-free, or you can spread the payments out over a number of years. In this case, the death benefit is tax-free, but interest on the accrued balance is taxable. Alternatively, the insured can elect to defer both the face value and the interest until some future date. In this case, the interest is taxable in the year received.