6.3 Settlement Options
Key Takeaways
- Settlement options are the methods of paying out a death benefit or cash value: lump sum, interest only, fixed period, fixed amount, and life income.
- Fixed period fixes the time and lets the payment float; fixed amount fixes the payment and lets the time float.
- Straight life income pays the most but stops at death; period-certain, refund, and joint-and-survivor add survivor guarantees at lower payments.
- Death benefit principal is income-tax-free, but interest credited under deferred options is taxable.
- Life income payments are part tax-free principal and part taxable interest, prorated over the recipient's life expectancy.
Settlement Options
Settlement options are the methods by which a life insurance policy pays out the death benefit to the beneficiary (or the cash value to the owner at surrender or maturity). Instead of taking a lump sum, the recipient can choose a structured payout. The policyowner may select the option in advance, or the beneficiary may choose at the time of claim if the owner left it open.
The exam tests the five standard options, how each handles principal and interest, and the tax treatment of the interest portion. Death benefit principal is generally income-tax-free; the interest earned under deferred or installment options is taxable.
The Five Standard Settlement Options
| Option | How it pays | Key feature |
|---|---|---|
| Lump sum | Entire amount at once | Default; principal is income-tax-free |
| Interest only | Insurer holds proceeds, pays interest periodically | Principal preserved; interest is taxable |
| Fixed period | Pays for a set number of years | Amount depends on period chosen; uses up principal and interest |
| Fixed amount | Pays a chosen dollar amount until funds exhausted | Period varies; you set the dollars, time floats |
| Life income | Pays for the recipient's lifetime | Cannot outlive the income; based on life expectancy |
A memory hook: fixed period fixes the time (the dollars float), while fixed amount fixes the dollars (the time floats).
Life Income Sub-Options
The life income option converts proceeds into a guaranteed lifetime stream, like an annuity. Because the insurer takes on longevity risk, the variations balance income size against guarantees:
- Straight life income (life only): highest payment, but payments stop at death with nothing to heirs.
- Life income with period certain: pays for life; if the recipient dies before a guaranteed period (e.g., 10 or 20 years), a beneficiary collects the remainder.
- Life income with refund (cash or installment): guarantees total payments equal at least the proceeds; any unpaid balance goes to a beneficiary.
- Joint and survivor life income: pays over two lives; income continues, sometimes reduced to two-thirds or one-half, until the second person dies.
Trap: straight life income gives the largest check but the least protection for survivors.
A beneficiary wants the highest possible monthly income for life and has no heirs to provide for. Which life income sub-option fits best?
Worked Numeric: Fixed Period vs. Fixed Amount
Suppose a beneficiary receives $100,000 in proceeds and the insurer credits 3% interest.
- Fixed period (10 years): The insurer solves for a payment that exhausts principal plus interest over exactly 120 months. Roughly $965 per month; payments end at month 120 regardless of balance.
- Fixed amount ($1,500/month): The beneficiary fixes the check size. Because $1,500 is larger than the fixed-period figure, the money runs out sooner — in this example after roughly 70 months — when principal plus credited interest is depleted.
In both, the interest credited each year is taxable income to the recipient, while the original death benefit principal is received income-tax-free.
Taxation Summary
| Payout situation | Tax treatment |
|---|---|
| Lump-sum death benefit | Principal income-tax-free |
| Interest-only option | Interest taxable each year; principal untouched |
| Fixed period / fixed amount | Principal tax-free; interest portion of each payment taxable |
| Life income | Each payment is part tax-free principal, part taxable interest, prorated over life expectancy |
The consistent rule: return of principal is tax-free; growth (interest) is taxable. This mirrors annuity taxation and is a frequent exam crossover. Note that proceeds may still be includible in the insured's estate for estate-tax purposes if the insured held incidents of ownership at death.
A beneficiary elects the interest-only settlement option on a $250,000 death benefit. How is the annual interest payment taxed?
Choosing a Settlement Option: Decision Factors
The beneficiary (or the policyowner, who may lock the option in advance) weighs several factors:
| Goal | Best-Fit Option |
|---|---|
| Maximum monthly income, no heirs | Life income (straight life) |
| Guaranteed minimum payout to heirs | Life income with period certain or refund |
| Income for a SET number of years | Fixed period |
| Income of a SET dollar amount until funds exhaust | Fixed amount |
| Preserve principal, take earnings only | Interest only |
| Full control of the money now | Lump sum (cash) |
If the policyowner selects and locks the option before death, it becomes irrevocable to the beneficiary - a tool to protect a spendthrift beneficiary from taking a lump sum and spending it quickly.
Fixed Period vs. Fixed Amount - The Inverse Relationship
These two are mirror images. With fixed period, you set the number of years and the insurer solves for the payment. With fixed amount, you set the payment and the insurer solves for how long the money lasts. In both, any interest credited extends value: a larger payment shortens the fixed-amount duration, while a longer fixed period lowers each payment.
Worked Numeric: Interest-Only and Life Income
Interest-only example. A $250,000 death benefit is left with the insurer under the interest-only option at a guaranteed 3 percent. The beneficiary receives:
$250,000 x 3% = $7,500 per year
The $250,000 principal stays with the insurer and passes income-tax-free to a contingent payee later, because it is death-benefit proceeds. The $7,500 interest is taxable each year as ordinary income - earnings are never part of the tax-free death benefit.
Life income taxation. When proceeds are paid as a life income, each payment is part principal, part interest. The principal portion (death benefit divided by life expectancy) is tax-free; the interest portion is taxable. This mirrors the annuity exclusion-ratio concept.
Exam trap: The death benefit itself is income-tax-free. But the MOMENT proceeds are held and earn interest, that interest becomes taxable. Lump-sum cash = fully tax-free; any installment plan = interest portion taxable.
A policyowner wants to ensure her adult beneficiary cannot squander the $300,000 death benefit all at once. The best action is to: