6.3 Settlement Options
Key Takeaways
- Settlement options control how death proceeds (or maturity values) are paid out instead of as a single lump sum.
- Interest only retains principal with the insurer and pays interest; the principal stays available for later withdrawal or another option.
- Fixed period pays the full amount (with interest) over a chosen number of years; fixed amount pays a chosen dollar amount until the fund is exhausted.
- Life income options pay for the beneficiary's lifetime; the pure life option pays most but stops at death with nothing to heirs.
- Only the interest portion of installment payments is taxable income to the beneficiary; the principal (death benefit) portion is income-tax-free.
A settlement option is the method by which the insurer pays the death benefit (or a matured endowment) to the beneficiary. The default is a lump sum, but the owner or beneficiary may elect an installment arrangement so the money is managed and stretched over time.
The Five Core Options
| Option | How it works | Best fit |
|---|---|---|
| Lump sum | Entire benefit paid at once | Beneficiary who wants full control |
| Interest only | Insurer holds principal, pays interest | Beneficiary not yet ready to spend principal |
| Fixed period | Pays full fund + interest over set years | Income needed for a known span (e.g., college) |
| Fixed amount | Pays set dollar amount until fund runs out | Beneficiary needs a specific monthly figure |
| Life income | Pays for the beneficiary's lifetime | Beneficiary fears outliving the money |
Memory hook: Fixed period = you pick the time, the payment is solved for. Fixed amount = you pick the payment, the time is solved for.
Interest-Only Option
The insurer retains the principal and pays the beneficiary interest at a guaranteed minimum rate (often with excess interest). The principal remains intact and can later be withdrawn or shifted to another settlement option.
- Principal stays safe with the insurer.
- Interest payments are taxable income.
- Useful as a holding pattern after a death while the beneficiary decides.
Fixed Period vs. Fixed Amount
Fixed period (period certain)
The whole proceeds plus interest are paid in equal installments over a chosen number of years. Larger principal or higher interest → larger payments. If the beneficiary dies before the period ends, remaining payments go to a contingent payee.
Worked example
$100,000 of proceeds over a 10-year fixed period, with interest, might pay roughly $10,600 per year (the extra over $10,000 is credited interest). The exact figure depends on the insurer's guaranteed rate.
Fixed amount
The beneficiary names the dollar amount per installment (e.g., $1,000/month). Payments continue, with interest credited, until the fund is exhausted. A higher chosen amount shortens the payout duration.
A beneficiary wants a guaranteed $1,500 every month and does not care how many years the payments last. Which settlement option fits?
Who Elects, and When
The owner can elect a settlement option while alive and may make it irrevocable so the beneficiary cannot demand a lump sum. If the owner does not elect one, the beneficiary chooses after the insured's death. This matters when the owner wants to control how a young or financially inexperienced beneficiary receives the money.
Spendthrift considerations
Electing an installment option with a spendthrift clause protects proceeds from the beneficiary's creditors and prevents the beneficiary from assigning or commuting future payments — a frequent reason owners pre-select an option rather than leaving a lump sum.
Matching the Option to the Need
| Beneficiary need | Best option |
|---|---|
| Keep principal intact, defer decision | Interest only |
| Fund a fixed timeframe (e.g., 4 years of college) | Fixed period |
| Receive a specific monthly check | Fixed amount |
| Guaranteed lifetime income, largest check | Pure life income |
| Lifetime income but protect heirs | Life with period certain / refund |
| Income for two lives (spouses) | Joint and survivor |
The exam often frames a short scenario and asks which option matches — anchor on whether the beneficiary fixes the time, the dollar amount, or wants lifetime protection.
Life Income Options
Life income options annuitize the proceeds so payments last the beneficiary's lifetime, protecting against outliving the money. The trade-off is set by how much death protection you keep for heirs.
| Sub-option | Payment size | At beneficiary's death |
|---|---|---|
| Pure / straight life | Highest | Payments stop — nothing to heirs |
| Life with period certain | Lower | Remaining certain payments go to a payee |
| Life with refund (cash/installment) | Lower | Unpaid balance refunded to a payee |
| Joint and survivor | Lowest | Continues to the surviving annuitant |
Exam tip: Pure life pays the largest monthly income precisely because it offers no survivor or refund guarantee. The more you guarantee to heirs, the smaller each payment.
Taxation of Settlement Payments
Death proceeds are income-tax-free as principal. When paid in installments, each payment is part return of the tax-free death benefit and part taxable interest the insurer credits.
Worked example
A $200,000 benefit is paid over 10 years at $22,000/year. Over the decade the beneficiary receives $220,000 total.
- Total received: $220,000
- Tax-free principal: $200,000
- Taxable interest (spread across payments): $20,000
Only the $20,000 of interest is reportable income; the $200,000 principal portion is received income-tax-free.
Interest-only option taxation
Under an interest-only election the principal is never paid out as installments, so every payment is interest — and therefore fully taxable each year. This contrasts with installment options, where each check blends tax-free principal and taxable interest.
Exam tip: The death-benefit principal is always income-tax-free; the only taxable piece of any settlement option is the interest the insurer credits while holding the funds.
A beneficiary elects a fixed-period settlement and receives $22,000 per year on a $200,000 death benefit. Which statement about taxation is correct?