6.3 Settlement Options
Key Takeaways
- The five standard settlement options are lump sum, interest only, fixed period, fixed amount, and life income.
- Fixed period sets the number of years (insurer computes the payment); fixed amount sets the payment (insurer computes the duration).
- Straight life income pays the most per period but stops at death; period certain, refund, and joint-and-survivor add guarantees and lower each payment.
- Death benefit principal is income-tax-free, but interest credited under any deferred option is taxable.
- Choosing a settlement option instead of cash does not make the interest tax-free.
Settlement options are the ways a beneficiary (or, for living benefits, the owner) can choose to receive policy proceeds other than as a single check. The exam expects you to recognize each option, when interest is taxable, and which option pays the most or guarantees income for life.
The owner may select a settlement option in advance, or leave the choice to the beneficiary. Once proceeds are left with the insurer, the company credits interest, and that interest is taxable income even though the death benefit principal is income-tax-free.
The Five Standard Options
| Option | How it pays | Key feature |
|---|---|---|
| Lump sum (cash) | Entire proceeds at once | Default; principal is income-tax-free |
| Interest only | Insurer holds principal, pays interest | Principal preserved; interest is taxable |
| Fixed period | Equal payments over a chosen number of years | Larger payment, shorter period |
| Fixed amount | Equal dollar payments until funds exhaust | You set the dollar amount, length varies |
| Life income | Payments for the beneficiary's lifetime | Cannot outlive the income |
Fixed-period and fixed-amount are mirror images: in fixed period you pick the years and the company computes the payment; in fixed amount you pick the payment and the company computes how long it lasts.
Both the fixed-period and fixed-amount options pay until the proceeds plus credited interest are exhausted, and both are temporary rather than lifetime arrangements. A shorter fixed period means a larger check; a larger fixed amount means the fund runs out sooner. Neither carries longevity risk because the insurer's obligation is capped at the proceeds.
By contrast, the interest-only option preserves the entire principal indefinitely, paying just the earnings. It suits a beneficiary who wants to leave the death benefit intact, perhaps to pass it on later, while drawing a modest taxable income stream in the meantime.
Life Income Sub-Options
The life income option converts proceeds into an annuity on the payee's life. Sub-types trade lifetime guarantees against the size of each check.
- Straight life income (life only): highest periodic payment, but payments stop at death with nothing to heirs.
- Life with period certain: pays for life, but if the payee dies early, payments continue to a contingent payee for the guaranteed period (e.g., 10 or 20 years).
- Life with refund (installment or cash refund): guarantees that total payments at least equal the proceeds; any unpaid balance goes to a beneficiary.
- Joint and survivor: pays over two lives, continuing (often at a reduced percentage) until the second person dies.
The more guarantees attached, the smaller each payment, because the insurer assumes more risk.
Worked numerics
Fixed period
Proceeds of $120,000 under a 10-year fixed period at a guaranteed rate produce roughly $1,060 per month (about $12,720 per year). Of each payment, the return of principal portion is tax-free and only the interest portion is taxable.
Interest only
Proceeds of $200,000 left at 3% interest only pay $6,000 per year ($200,000 x 0.03). The full $6,000 is taxable interest; the $200,000 principal remains and is later paid under another option or in a lump sum, tax-free.
Fixed amount
Proceeds of $120,000 drawn as a fixed amount of $1,500 per month ($18,000 per year) last about 6.7 years before exhaustion if no interest were credited; crediting interest extends the duration slightly. Choosing a larger monthly amount shortens how long the income lasts.
Taxation snapshot
| Money received | Taxed? |
|---|---|
| Death benefit principal | Income-tax-free |
| Interest credited under a deferred option | Taxable as ordinary income |
| Exclusion (principal) portion of installment payments | Tax-free |
| Interest portion of installment payments | Taxable |
Exam trap: choosing a settlement option instead of a lump sum does not make the interest tax-free. Only the death benefit principal escapes income tax.
A beneficiary wants the largest possible monthly check for life and is not concerned about leaving anything to heirs. Which settlement option fits best?
A beneficiary leaves $200,000 of life insurance proceeds with the insurer under an interest-only option paying 3%. What are the income tax consequences of the $6,000 paid each year?