6.3 Settlement Options
Key Takeaways
- Settlement options control how death proceeds are paid out: lump sum, interest only, fixed period, fixed amount, or life income.
- Under interest only, the insurer holds the proceeds and pays interest; the principal remains intact for a later payout.
- Fixed period pays a larger check over a set number of years, while fixed amount pays a set dollar figure until the fund and interest are exhausted.
- Life income options guarantee payments for life; adding a period certain or refund feature lowers each payment but protects against early death.
- Interest earned on settlement proceeds is taxable income, while the death-benefit principal portion is generally income-tax free.
Settlement options are the methods by which the death benefit (or matured endowment) is paid to the beneficiary. The owner may select an option in advance, or the beneficiary may choose at the time of claim if the owner left the choice open. The default is a lump sum.
The Five Core Options
| Option | How it pays |
|---|---|
| Lump sum | Entire proceeds at once (default) |
| Interest only | Insurer holds principal, pays interest periodically |
| Fixed period | Equal payments over a set number of years |
| Fixed amount | Set dollar payment until fund + interest run out |
| Life income | Payments guaranteed for the payee's lifetime |
Each non-lump-sum option leaves money with the insurer, which credits interest — and that interest is the taxable piece. Settlement options are valuable when a beneficiary is young, inexperienced with money, or wants a guaranteed income stream rather than a single large check that could be spent quickly or lost to poor investments. The owner can lock in an option so the beneficiary cannot change it, which is common when the beneficiary is a minor or has special needs.
Interest Only
Under interest only, the insurer retains the entire death benefit and pays the beneficiary only the interest it earns, at a guaranteed minimum rate. The principal is preserved and paid out later, often when a child reaches a target age or under a follow-up option.
- Good for a beneficiary who needs income now but wants to keep the principal intact.
- The interest received is taxable income each year.
Fixed Period vs. Fixed Amount
These two options are mirror images and a classic exam trap.
- Fixed period — you pick the number of years; the insurer solves for the payment size. A shorter period means larger checks.
- Fixed amount — you pick the payment size; the insurer solves for how long payments last. A larger check means the fund empties sooner.
Worked Comparison
Assume $120,000 of proceeds (ignoring interest for clarity).
| Choice | Variable solved | Result |
|---|---|---|
| Fixed period: 10 years | Payment | ~$1,000 per month |
| Fixed period: 5 years | Payment | ~$2,000 per month |
| Fixed amount: $1,000/mo | Duration | ~10 years (longer with interest) |
| Fixed amount: $2,000/mo | Duration | ~5 years |
Interest credited by the insurer makes real payments slightly higher or the fund last slightly longer than these principal-only figures.
A beneficiary wants a guaranteed monthly check of exactly $1,500 for as long as the proceeds last, with the insurer determining how many months that will be. Which settlement option fits?
Life Income Options
Life income options guarantee payments for the payee's entire life, transferring longevity risk to the insurer. The payment size depends on the payee's age and sex (mortality). Pure straight life income pays the most per dollar but stops at death — even if death is early — so insurers offer protective variations.
| Variation | What it adds | Effect on payment |
|---|---|---|
| Straight life | Lifetime only | Highest payment |
| Life with period certain | Guarantees payments for a minimum term (e.g., 10/20 years) | Lower payment |
| Life with refund (cash/installment) | Returns any unpaid principal to a second payee | Lower payment |
| Joint and survivor | Continues to a second life | Lowest payment |
Trap: Adding any guarantee (period certain, refund, survivor) reduces each payment because the insurer takes on more obligation.
Taxation of Settlement Proceeds
The death-benefit principal is generally received income-tax free under Internal Revenue Code Section 101(a). When proceeds are left under a settlement option, the interest the insurer credits is taxable income to the beneficiary in the year received.
- Lump sum: principal is tax-free; no ongoing interest is taxed.
- Fixed period / fixed amount / life income: each payment is split into a tax-free return of principal and a taxable interest portion.
- Interest only: the whole periodic payment is interest, so it is fully taxable, while the preserved principal stays tax-free when finally paid.
A beneficiary elects to leave a $400,000 death benefit with the insurer under the interest-only option, receiving $1,400 of interest each month. How is that interest treated for income tax?
Joint and survivor settlement
A joint-and-survivor life income option pays an income while either of two payees (often spouses) is alive, then continues — sometimes at a reduced level such as joint-and-two-thirds or joint-and-one-half — to the survivor. Because two lives must die before payments stop, the periodic payment is lower than a single-life income on either life alone.
Right to choose and change the option
The policyowner normally selects the settlement option during life. If the owner makes no election, the beneficiary may choose at the time of claim. An owner can also lock in an option irrevocably, which can shield the proceeds from a beneficiary's creditors and prevent a lump-sum spend-down — a planning tool the exam links to spendthrift protection.
Spendthrift clause
When proceeds are left under an installment or interest option, a spendthrift clause bars the beneficiary from commuting (cashing out) future payments and shields them from creditors until paid.
An owner wants death proceeds paid as income over the lives of two spouses, continuing in full until both have died. Which settlement option fits, and how does its payment compare to a single-life income?
Lump sum, the default option, and commutation
The lump-sum cash payment is the default settlement if the owner or beneficiary elects nothing else, and the lump-sum death benefit is income-tax-free. When proceeds are instead left under an installment or life-income option, the principal portion remains tax-free while the interest element is taxable. Some options allow commutation (cashing out the remaining value), but a spendthrift clause can bar it to protect the beneficiary, tying settlement choices back to creditor protection and tax treatment.