You spend countless hours researching the best life insurance companies, narrowing down your select few and the right policy, only to have all your careful planning go up in smoke due to a failure to properly designate your beneficiary or failing to update your policy.
The following article will address the various concerns with naming different life insurance beneficiaries that you need to be aware of to avoid sabotaging your legacy.
Choosing a Life Insurance Beneficiary
Selecting a life insurance beneficiary is a crucial step in providing protection for your loved ones if something should happen to you. It also has important estate planning ramifications.
Choosing your beneficiary or beneficiaries may not seem like a complicated process, however, it is important to understand the rules associated with selecting various types of beneficiaries to avoid unintended or deleterious consequences.
As a result, making sure you understand the details involved with selecting a beneficiary is essential to ensuring that your insurance proceeds go to the people you want them to go to without unnecessary complications.
Issues relating to taxation, legal entanglements, and costs can arise if you make a mistake when designating a life insurance beneficiary.
This article will cover the ins and outs of choosing a beneficiary in various types of situations to help you avoid the difficulties that can occur if a beneficiary is selected improperly.
Who Can Be a Life Insurance Beneficiary?
You have a variety of options when it comes to naming a beneficiary on your life insurance policy. They include:
- Spouse: A spouse is a common life insurance beneficiary. In community property states, spouses must give their approval if another person is selected as the beneficiary.
- Domestic partner: A domestic partner is another common life insurance beneficiary choice.
- Children: Please note that life insurance companies typically won’t pay death benefit proceeds to minor children. Ways to enable your minor children to benefit from life insurance are discussed later in this article.
- Trust: A trust, whether in the form of a living trust, charitable remainder trust, or some other type, can be a life insurance beneficiary. The trustee is charged with managing the life insurance proceeds for the benefit of the trust and its beneficiaries.
- Legal Guardian: A legal guardian can be named as the beneficiary of an insurance policy on behalf of a minor child or a person with special needs.
- Business: Key person insurance typically involves a business purchasing insurance on a key executive with the business serving as the beneficiary. The proceeds from insurance used in this manner are often used to help provide liquidity to buy out the deceased owner’s share or for other purposes.
- Non-profit organization: a non-profit organization such as a charity can be named as the primary or contingent beneficiary of a life insurance policy.
- Estate: If your estate is selected as the beneficiary the proceeds are distributed to the court-approved Executor named in your will. Your estate can only be selected as a beneficiary if you have created an official will. You should discuss the tax consequences of selecting your estate as the beneficiary with your tax advisers.
Choosing Primary and Contingent Beneficiaries
Your primary beneficiary receives the proceeds of the life insurance policy upon your death. If they predecease you the proceeds would instead go to your contingent, or secondary, beneficiary.
If you don’t name a contingent beneficiary and your primary beneficiary dies before you do, the proceeds would go to your estate, where they become subject to probate and the extra expenses this entails. For this reason, it is generally advisable to select both a primary and contingent beneficiary on a life insurance policy.
When you select more than one beneficiary you must select how the proceeds will be distributed to your beneficiaries in the event one or more of them predecease you.
The two choices you can make in this regard are per stirpes and per capita.
Per stirpes: This method, which means by family line, enables each beneficiary’s heirs to inherit their portion of the proceeds if the beneficiary dies before you do. For example, if you have two beneficiaries slated to split the death benefit, and one of them predeceases you, leaving two heirs behind, upon your death 50% of the policy’s proceeds would go to the living beneficiary and 50% would be split between the other beneficiary’s heirs.
Per capita: This method, which means per head, allocates your proceeds equally to each surviving beneficiary or heir of a deceased beneficiary. Using the example above, the policy proceeds would be split equally between the three remaining beneficiaries rather than 50% going to the surviving beneficiary and 25% each going to the two heirs of the deceased beneficiary. As a result, each surviving beneficiary would receive approximately 33% of the proceeds.
A tertiary beneficiary comes third in line to receive the benefits of an insurance policy, after primary and contingent beneficiaries in the line of succession.
If both the primary and secondary beneficiaries predecease you, the tertiary beneficiary would receive the death benefit proceeds from the policy.
An example of a tertiary beneficiary for life insurance would be if you name your wife as the primary beneficiary, your son as the secondary beneficiary, and your son’s daughter, your grandchild, as the tertiary beneficiary. If your wife and son die before you, your granddaughter, the tertiary beneficiary, would receive the insurance proceeds upon your death.
Revocable and Irrevocable Beneficiaries
Beneficiaries can either be revocable or irrevocable, depending upon the situation.
In most cases, designating revocable beneficiaries is the preferred method, enabling you to respond to changing circumstances in your life: for example, a divorce or the death of a beneficiary.
In certain cases, such as the establishment of an irrevocable life insurance trust or charitable remainder trust, the designation of a beneficiary, in this case, the charity, must be irrevocable.
Mistakes to Avoid When Selecting Beneficiaries
There are different dangers when designating an insurance beneficiary. We provide 7 examples below.
Designating Minor Children as Beneficiaries
As mentioned earlier, insurance companies will not pay insurance policy proceeds directly to minor children. If you name a minor child as a life insurance beneficiary the court will appoint a guardian to represent the child upon your death, which can be a costly proposition, reducing the amount of money available to the child.
A better solution may be to use the Uniform Trust for Minor’s Act (UTMA) to appoint a trustee to receive the proceeds on behalf of the child. You can also set up a trust for the child’s benefit and have that trust be the beneficiary of the policy.
In the case of life insurance for special needs planning, if you would like a child who requires lifelong special assistance to benefit from insurance proceeds, it is important to take steps to make sure these proceeds don’t disqualify the child from receiving government assistance.
A person receiving a gift of greater than $2,000 will not quality to receive Supplementary Security Income and Medicaid according to federal law.
Therefore, rather than making such a child a beneficiary, a better approach may be to establish a special needs trust for the child to serve as the beneficiary. The trustee appointed to oversee the trust can manage the funds on the child’s behalf.
Will vs Insurance Beneficiary
A life insurance policy is a contract separate from, and NOT subordinate to, your will and any of its provisions.
Given that life insurance can make up a significant portion of the assets left by an individual to his or her heirs, it is important not to make the mistake of assuming that any instructions in your will can be used to determine how life insurance death benefit proceeds are distributed.
Only the beneficiary designation submitted to the insurance company will be followed when distributing life insurance death benefits.
Forgetting to Change Your Beneficiary Designation When Getting Divorced or Remarrying
It is important to make sure that you review your life insurance beneficiary designation after a divorce or remarriage to ensure that it accurately reflects your current situation. The increasing prevalence of blended families can lead to complex beneficiary designation scenarios.
Check your beneficiary designations after any major life change to makes sure that they correspond to your wishes to ensure that your life insurance proceeds go to the desired recipients.
Note that while you can typically select anyone you have a relationship with as a life insurance beneficiary, there are limits to this ability in community property states. As mentioned earlier, if you reside in a community property state and select someone other than your spouse as the beneficiary, your spouse is required to sign a form acknowledging that they agree to give up their rights to the insurance proceeds.
Disregarding Tax Consequences
Generally, life insurance is not taxed. However, this is not the case when the policy owner, insured, and beneficiary of a policy consist of three separate individuals. When this occurs, the death benefit may be viewed as a gift to the beneficiary subject to taxes.
For instance, if a husband is the owner of a policy and his wife is the insured, with their son the beneficiary, the IRS may consider this an attempt to circumvent the gift tax and declare that the insurance death benefit proceeds are subject to taxes, with those taxes charged to the husband as the owner of the policy.
To get around this type of issue, one solution would be to make the husband both the owner of the policy and the person insured by the policy. While this typically resolves the problem, in community property states, where a husband and wife are presumed to own assets jointly, there can be issues with such an approach. In such cases, consulting with your tax adviser regarding the issue is recommended.
Not Specifically Naming A Beneficiary
Be careful not to use broad terms to identify your beneficiaries, such as “my children” or “my surviving heirs,” if possible. Doing so opens the door for legal challenges that could result in your beneficiary or beneficiaries incurring legal fees that significantly reduce the amount they receive in life insurance death benefit proceeds.
For example, if you name “my wife” as your beneficiary, but have divorced and remarried since that time, it can lead to complications as to who should receive the life insurance proceeds.
Rather, use your life insurance beneficiary’s full legal name, date of birth, and even social security number, if possible.
Using Dollar Amounts Rather Than Percentages
Because the death benefit amount of your cash value life insurance policy may change over time as its cash value grows, make sure to specify a percentage of the proceeds to go to your beneficiaries rather than selecting a dollar amount.
For example, if your death benefit is currently $300,000, rather than state $100,000 to each of my 3 children, instead state 1/3 to each of my children. That way, if your death benefit has grown, your children will receive the full amount you intended without additional paperwork and potential costs, which could include legal fees and court interaction.
Selecting Your Estate as Beneficiary When You Want to Direct Who the Funds Go to
When your estate is named as the beneficiary the funds must go through probate and are subject to lack of privacy, fees and potential taxation and can be attached by creditors. If you want the proceeds to go to the heirs of your estate, it is typically better to name them specifically as beneficiaries rather than having your estate be the beneficiary.
While selecting a life insurance beneficiary may seem like a relatively straightforward proposition, there are a number of scenarios where complexities can arise. In these cases, it is important to understand the implications involved in making your selection. In cases where you are unsure of the ramifications of selecting a beneficiary, you may want to consult your financial, tax, or legal advisor for advice pertaining to your personal circumstances.