You Received a life insurance payout – now what?

Experts advise not making quick decisions

Women and men who lose a spouse often receive substantial amounts of money as beneficiaries of a life insurance policy. If the couple previously engaged in financial and estate planning, the surviving spouse probably already has a roadmap of how the funds were intended to be used. But families who had not already planned ahead for the death of a spouse – or other relatives who were not expecting to receive an insurance payout – may not be prepared for the unanticipated windfall.

Life insurance policies give the surviving family members the ability to deal with the stress of losing a loved one without having to worry about their financial situation, including the loss of the deceased’s paycheck. However, a large payout means the widow or widower will eventually have to decide whether to spend, save, or invest the funds they receive.

The choices can be overwhelming as one considers what to do with the proceeds from a life insurance policy (or an annuity, savings account, or investment portfolio). While most beneficiaries receive a lump sum from the insurance company, most carriers have options that can provide a cash flow for years to you. You can typically receive the death benefit in installments; convert it to an annuity; or take a hybrid approach, such as taking part of the money as an annuity and the remainder as a lump sum.

The first priority is making sure you can take care of your living expenses for the foreseeable future. If you cannot meet your monthly expenses, keeping cash on hand becomes the main order of business. Other considerations while weighing your options include:

Taxes: Life insurance proceeds are typically not taxable. However, if you invest the funds in an investment vehicle such as stocks that pay dividends or annuities that accumulate interest, you will be taxed on the income generated and any capital gains. Also, you cannot directly roll life insurance payouts over to an IRA, 401(k), or similar retirement fund.

Pay off debt: The Federal Reserve Bank of New York reported that total household debt had risen to $14.96 trillion in June 2021. COVID-19 has hastened that increase, with a September 2021 Bankrate survey finding 42 percent of consumers adding to their credit card debt since the pandemic began. Using life insurance proceeds to pay off credit cards and other high-interest debt will reduce your expenses and put more money in your pocket. However, you should weigh which debts to pay and when to achieve for maximum effectiveness.

Bank the money: Most people do not have an emergency fund to cover three to six months of expenses. A high-yield savings account or a low-risk investment will protect your principal until you decide how you should spend it.

Create a legacy: Establish a fund to finance your children’s or grandchildren’s education, or contribute to a worthwhile charity.

Experts interviewed by Advisors Magazine said that the first thing beneficiaries should do after receiving life insurance benefits is to take plenty of time to think and heal before you act.

Rich oval“I would caution people not to jump into any big investments right away,” said financial advisor Richard Babjak, ChFc, of Midway Wealth Partners in Arlington Heights, Illinois. “Take a step back before you make a decision too quickly.”
That approach is particularly important when considering how to use life insurance proceeds after the death of a spouse, added Usha Rackliffe, professor of accounting at Goizueta Business School at Emory University in Atlanta. Periods of sadness and bereavement are not the best time to jump into major decisions.

“Sometimes decisions paralyze people,” Rackliffe added. “They think, ‘Oh my God, what am I going to do now?’ When you’re faced with an OMG moment, the best choice is to do nothing just yet. If you don’t have to make a decision, don’t make the decision; hold off until you get to a calm place in your mind. You don’t want to jump into something just yet. You want to be cool, calm, and collected in you approach.”

Deciding How to Move Forward
Babjak said there are five basic steps he follows when helping clients to decide what to do with the proceeds of a life insurance policy after the loss of a spouse, parent, or other loved one. This same approach can also be followed by other people who have received an unexpected windfall.

1. Step back: “This period of time can be a very emotional time for most people,” he said. “A surviving spouse should avoid making big financial decisions too soon, such as downsizing their house or making a major investment.” He added, “How long it takes depends on the individual. Sometimes it can be a few months; sometimes longer.”

2. Create a financial plan: Even if the deceased had already put a financial roadmap in place, the surviving spouse should revisit those details. Some advisors spend more time with the spouse who mainly takes care of the finances, rather than engaging with both spouses equally, Babjak said. Things work more smoothly when advisors build relationships with both spouses. People who already have a relationship with a financial advisor find it easier to relate to and work with them during uncertain times.

3. Assess financial needs: This also becomes easier when there is an existing financial plan in place. Typical questions to consider include whether the survivor needs monthly income or can invest the proceeds for future growth. Babjak said looking at cash flow is the first priority before addressing other needs. Many decisions are driven by the spouse’s stage of life. Is the surviving spouse retired? Are there children who will need money to go to college? These factors help determine the appropriate investments needed.

4. Update your risk profile: “The original client may have had a high-risk tolerance, but the surviving spouse could have a different perspective,” he said. “Often when money is inherited, the survivor thinks, “I can’t touch that money” or “They wanted me to do something specific with it.’ Emotions come into play when they think about how they will use the money. However, you will proceed, the risk you can tolerate must match your personality, not that of the deceased.”

5. Allocating the money: What types of investments are needed? Should they be liquid assets, or should one invest for the long term? Should the plan provide regular income? Will you pay off debt? Babjak added some clients may need to scale back their lifestyles, while others receive enough money that their lifestyle will improve.
“Over the years, as my client base has aged, I’ve lost several clients each year,” Babjak added. “There is a lot of administrative work to be done, such as retitling assets. It’s also helpful for them to have someone who can show them that everything will be okay.”

The ABCD Approach

Rackliffe, who teaches a personal financial planning course at Emory, said that when people consider how to use proceeds from a life insurance policy or an unexpected windfall, she recommends making a list of relevant factors by following an ABCD model.

UshaR“The A, B, C, and D approach covers your assets, bucket list, cash flow, and debt,” Rackliffe said. “You have to look at things through all four lenses to figure out what use of the proceeds is right and appropriate.” Those factors are:

A. Assets: What assets do you already have? A house? A car? Investments? A 401(k)? Put all your assets on the list.

B. Bucket list. “What do you want to do in your life?” she asks. “What are the big things that you think will make your life complete, and the things you feel good about wanting to do. There’s never a better time for someone to think about their bucket list than when they face mortality.”

C. Cash flow: Write down how much cash you have coming in and how much is going out. Do you have enough cash flow? Too little? Too much? Where does the money come from and where is the money going?

D. Debt: “Not all debt is bad,” Rackliffe noted. “There is good debt and there is debt that is not so good. Most people have a home mortgage, a car loan, credit card debt, and other types of debt. Go down the list and decide which is good and which is not.”

Setting Priorities

Make lists that cover all four ABCD factors. To evaluate how you should allocate your life insurance proceeds, Rackliffe recommends starting from the bottom of the list and working your way to the top. Begin with debt; then address cash flow, the bucket list, and finally, assets.

Debt: “This is the easiest one to go down the list and say what you should pay off,” she said. “In general, not-so-good debt is where you owe a high interest rate. If you owe a high interest rate on anything, that one is begging us to pay it off.”

For example, assume someone owes $10,000 on a credit card that carries a15.9 percent annual interest rate. It makes sense to pay off this credit card because retiring the debt means you are essentially earning a 15.9 percent return.

“It is hard to earn that return anywhere else,” Rackliffe noted. “If you have a windfall, this is the first place to look. I believe something with high interest always takes priority because it will free up immediate cash, as you were presumably paying something every month.”

China manSome people may wonder whether they should pay off their mortgage. Rackliffe said mortgages are usually “good debt” that provide several benefits. Since interest rates are low, people will not save a lot of money paying off their house. Many people would also lose the income tax break they get from the mortgage interest deduction. Mortgages are also tied to a sound underlying asset: homes whose values tend to appreciate over time.

She added, “Peace of mind is different things for different people. For me, peace of mind is having access to cash. For some people, it’s paying off the mortgage. You just have to think through what brings you pleasure in life.”
A student loan can also be good debt, she added, depending on the interest rate. She considers a high interest rate to be one higher than nine to ten percent.

Cash Flow: After debt, the next priority is making sure you have enough cash flow to meet your expenses, Rackliffe said. People should list all their sources of income (such as paychecks, dividends, or pensions) and all their expenditures, and then compare the two totals.

“Some people live paycheck to paycheck, and others have more cash available than their paycheck,” she said. “This helps you decide whether you are in a good place for cash flow. The question is: how close together are those inflows and outflows? If you find yourself short of money each month, that’s a problem. Then you have to ask yourself, where’s the money going?”

If you find yourself pinched, she added, you need to generate more cash flow. You can either increase your inflow (income) or reduce the outflow (expenses). For example, paying off credit card debt with a life insurance payout will improve your cash position and reduce outflow. Investing those proceeds in an index fund can generate income that provides you a regular stream of money.

Bucket List: Different things are important to different people, Rackliffe said. Some people want to take a trip around the world; others might want to create a legacy for their grandchildren or the favorite causes. Put your list in priority order that emphasizes the things that would make you the happiest. Everything on your bucket list will cost money, she added, so decide what is most important from a big picture perspective.

Assets: Finally, look at what kind of assets you own, both short-term and long-term. Consider how liquid those assets are in case you need to access the funds on short notice. People at older ages may also need to consider assets that would fund their future long-term medical care expenses. The more assets you have, she added, the more flexibility and choices you have.

“It doesn’t have to be crazy complicated,” Rackliffe concluded. “I tell people to approach this in a simple way. ABCD shines the light on every part of what a well-lived life is meant to be, both now and in the future.”


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