People purchase life insurance policies to protect their families financially—but will those policies actually benefit the intended individuals? That depends on whether the policyholder makes smart life insurance beneficiary decisions.
Bottom Line Personal asked insurance expert Lee Slavutin MD, CLU, AEP, what policyholders need to know when choosing life insurance beneficiaries as well as ways that beneficiary selection can go wrong…
The beneficiary of a life insurance policy is the person or entity that will receive the policy’s death benefit when the insured individual dies. Policy owners can name whomever they like as beneficiary or even name multiple “co-beneficiaries.” The most common scenario is for a married person to name his/her spouse as beneficiary, but it’s certainly not unusual to name other relatives or trusts or—in the case of policies purchased to protect business interests—to name a business or its owners.
Selecting life insurance beneficiaries typically means making more than one decision. In addition to a “primary beneficiary,” it’s usually worth naming one or more “contingent beneficiaries.” These contingent beneficiaries, also known as “secondary beneficiaries,” receive the policy’s death benefit if the primary beneficiary dies prior to the person whose life is insured. Example: A married person who names his spouse as primary beneficiary might name his children as contingent beneficiaries.
When selecting your life insurance beneficiaries, beware of these sticky situations that sometimes arise…
Some policyholders name their estate as the beneficiary Problem: When this happens, the policy’s death benefit goes to the deceased person’s estate and is distributed along with his/her other assets, likely through the probate process. That can dramatically slow payments—life insurance policies typically pay death benefits within two to three weeks, but probate can take six months or longer. Also: Probate fees might eat into the amount that beneficiaries eventually receive
Self-defense: Always name a beneficiary for a life insurance policy. And if any of your beneficiaries die, contact the insurance company to update the policy.
Policyholders can name minor children as beneficiaries. Problem: If those children are still minors when the insured person dies, the court likely will appoint a guardian to look after the money until those minor children reach adulthood. The age of legal adulthood typically is 18, but it is as high as 21 in some states. That’s not ideal—the appointed guardian might not be the person the policyholder would have selected for this important role, and he/she might receive fees for his efforts paid out of the death benefit, reducing the amount that eventually reaches the beneficiaries. What’s more, not all young adults are capable of responsibly managing sizable sums of money when they turn 18…or even 21.
Self-defense: If your life insurance beneficiaries include minor children, have a trust created…name that trust as the beneficiary of your life insurance policy…and name the minor children the beneficiaries of that trust. Choose people to oversee this trust (trustees) in whom you have great confidence, and have this trust manage the money until the beneficiaries reach an age you consider appropriate to take control.
Naming a spouse as beneficiary is very common, but occasionally married people instead select the insured’s spouse as a policy owner, with someone else—perhaps the couple’s kids—named beneficiaries. A person might name a spouse as owner if he/she is concerned about creditor protection, although trusts are better protection vehicles. Problem: When the owner, the insured person and the beneficiary of a life insurance policy are three different people, it creates what’s known in the industry as the “Goodman triangle” (named after the Goodman court case)—an obscure situation in which the policy’s death benefit might be legally considered a gift and thus subject to gift taxes. The lifetime gift-and-estate-tax exclusion currently is $13.99 million—an amount so high that gift taxes might not seem like a factor worth worrying about for most families, but that exclusion could be lowered significantly before the insured person dies.
Self-defense: Avoid this insurance policy ownership arrangement if possible.
This is an extremely common arrangement, but for the very wealthy it can lead to unnecessary estate taxes. Problem: The death benefit from one spouse’s insurance policy can end up in the estate of the surviving spouse. As noted above, only high-net-worth families need to worry about estate taxes, but the fact that a family’s assets fall short of the current $13.99 million gift-and-estate-tax exclusion doesn’t guarantee that estate taxes won’t become an issue down the road.
Self-defense: If your estate is sufficiently large that you discuss estate-tax planning strategies with an attorney, ask that attorney whether it makes sense to adjust the beneficiary of your life insurance policy. One potential option: Have a trust created to serve as both owner and beneficiary of a policy.
It is fairly common for policyholders to forget to change their beneficiary selection when they divorce. Problem: The Supreme Court has ruled that former spouses are entitled to these death benefits when this occurs. Many—but not all—states have now implemented “automatic revocation upon divorce” rules that attempt to solve this problem by automatically removing the former spouse as beneficiary when the divorce is finalized, but these rules are not panaceas.
Self-defense: Update your beneficiary promptly if you divorce rather than rely on automatic-revocation-upon-divorce rules. Your state might not have such a rule, and even if it does, that rule could be changed before you die…there might be enough wiggle room in your state’s rule that a lawyer could challenge it…and/or you might later move to a state that doesn’t have this rule.
Problem: If a policyholder is married…lives in Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin…and paid life insurance policy premiums using marital assets, then community property rules might dictate that his/her spouse is entitled to a portion of the death benefit even if someone else is named beneficiary.
Self-defense: If you live in a community property state and want to name someone other than your spouse as beneficiary, discuss this with an estate-planning attorney. Your spouse might have to sign a form waiving his/her right to the death benefit.
Businesses often insure the lives of owners or key employees to protect the business’ financial interests. But the beneficiaries of these policies should be the business itself and/or stakeholders in that business. Occasionally business owners instead have their businesses purchase policies on their lives that name their spouses or other loved ones as beneficiaries—they think this creates a tax savings by making the premiums paid for the policy a business expense. Problem: The IRS may rule that the death benefits paid by such policies are taxable distributions from the business—so rather than create a tax savings, this strategy is likely to trigger a tax bill for beneficiaries.
Self-defense: Do not use your business to purchase a life insurance policy that benefits your loved ones, not your business.
This sounds perfectly reasonable—surely the names listed as beneficiaries on an insurance policy are that policy’s beneficiaries. Problem: Life insurance policies can remain in effect for many decades, which is more than enough time for a policyholder to change his/her beneficiaries, then forget having done so. Such changes would, of course, not be reflected on the original policy document.
Better: Request that the insurance company send you a letter identifying your policy’s current beneficiaries.
Policyholders sometimes want to leave life insurance death benefits to their children or their grandchildren should their children die before they do. Problem: Simply listing one’s children in a policy’s “primary beneficiary” box and the grandchildren as “contingent beneficiaries” might not accomplish this as well as they hope. Example: A policyholder has two children, each of whom has children of their own. He lists his kids as co-primary beneficiaries and his grandkids as contingent beneficiaries. If one of the policyholder’s children dies before the policyholder, the policy’s death benefit won’t be divided between the surviving child and the deceased child’s kids—the entire benefit will go to the surviving child as the only living primary beneficiary.
Better: If you want your policy’s death benefit divided in any sort of complex or nuanced manner, name a trust as the policy’s owner and beneficiary. The estate-planning attorney who creates this trust can include the precise asset distribution you have in mind in the trust documents.
