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Life Insurance 101 (Part 2): What You Need to Know About Beneficiary Designations

Life Insurance - UmbrellaBy: Amanda Dorio, Esq.

To follow last week’s introduction to life insurance, it’s important to know that many different types of people can benefit from having adequate life insurance coverage. Here are a few of the most common groups:

  • Business owners. Suppose you own a business and want to leave it to some but not all of your children. In that case, a life insurance policy can provide cash to the children who are not receiving an interest in the business, equalizing the value of each child’s inheritance. A surviving business partner can also use life insurance proceeds to buy the deceased partner’s interest from their family. The deceased partner’s loved ones get the money without the surviving partner spending money from the business or their own pocket, and the business can continue uninterrupted.
  • Parents with young children. A life insurance policy can help pay for the expenses of raising children after their parents are deceased, reducing their guardian’s financial burden. Life insurance can also provide for a surviving parent if the deceased parent was the family’s primary source of income.
  • Anyone caring for a disabled family member. A life insurance policy can provide money for continuing care for family members with long-term disabling health conditions. However, suppose they are currently receiving or eligible for government assistance. In that case, you must exercise additional caution when providing them with funds from life insurance, so the family member is not disqualified from receiving those benefits.
  • Charitably-inclined individuals. A life insurance policy effectively funds your charitable endeavors without taking away from other accounts or property you may want to leave to your loved ones. In addition, life insurance can enable you to leave a more significant gift to the charity at your death than you would have if you had been making lifetime contributions.
  • People facing a large estate tax bill at death. If all of your accounts and property value is more than the lifetime exclusion amount at your death, estate tax may be due. Life insurance can provide your loved ones with cash to pay the tax. This cash can be extremely helpful if your accounts or property would be difficult to cash in or sell to pay the tax.

Importance of the Beneficiary Designation

A common misconception people have about life insurance is that they only need to designate their spouse, child, or loved one as the policy’s beneficiary to ensure that the life insurance benefits will be available to the beneficiary when they die. Below are some examples of results when you list certain classes of beneficiaries.

  • No beneficiary. Suppose you do not fill out the beneficiary designation before you die. In that case, the death benefit will be distributed according to the policy agreement’s default rules, which may give the proceeds to your spouse or heirs, as defined by the plan agreement or applicable state law, or to your estate, which will require your loved ones to go through the costly, time-consuming, and public probate process.
  • A charity as beneficiary. For the philanthropically inclined, naming a charity as a beneficiary means that the death benefit will be immediately paid to the charity upon your death. This timing can be helpful if the charity needs the money quickly or for a large project.
  • A minor as beneficiary. Depending on your family situation, you may be inclined to leave the money from a life insurance policy to your minor child or grandchild. However, because a minor cannot legally own or control their money, a court would have to select someone to hold the money on the minor’s behalf until they reach the age of majority (eighteen or twenty-one, depending on your state). At that time, the money would be turned over in full to the beneficiary, who would be able to spend it however they choose with no protection.

Examples

It may be helpful to have real-life examples to understand the importance of the beneficiary selection.

Single Mother

Kate, a single mother, named her ten-year-old son Ryan as a beneficiary of her life insurance. She passes away when he is twelve. The court names a relative as a guardian (sometimes referred to as a conservator) for Ryan until he is legally an adult. By the time Ryan reaches his eighteenth birthday, his inheritance has been partially spent on court costs, attorney’s fees, and guardian’s fees. In addition, its value has not kept pace with inflation because of the restricted investment options available to guardians. Kate had hoped that the life insurance proceeds would be available to pay for Ryan’s college expenses, but because of the costs and lack of investment flexibility, there is less money available to Ryan. Ryan receives the remaining funds, spends them frivolously, and within a year or two, has nothing left.

An Adult, or Surviving Spouse, as Beneficiary

While an adult can receive the money from the life insurance policy immediately, this solution may still not be ideal. After the beneficiary receives the money, they can spend it on whatever they choose; it could also be taken by a divorcing spouse or become subject to collection for an outstanding debt or judgment. Depending on the individual, the money may not last long.

Robert identified his wife, Brenda, as the beneficiary of his life insurance policy. At Robert’s death, Brenda does receive the death benefit from the insurance policy, but when Brenda remarries, she adds her new husband’s name as a joint owner of the bank account where she deposited the death benefit. In so doing, she inadvertently leaves the entire death benefit from Robert’s life insurance to her new husband instead of to the children she and Robert shared, as they had discussed before his death and as indicated in her will.

Name a Trust as the Beneficiary of Your Life Insurance

A common method for leaving money and property to loved ones in an estate plan is by titling assets, so they are owned by the trust or making the trust the beneficiary of the account or property, with a spouse or child as the trust’s beneficiaries. The same approach may also be used for life insurance policy proceeds. Two popular ways to achieve this result are naming a revocable living trust as a beneficiary and setting up an irrevocable life insurance trust.

Revocable Living Trust

For individuals with accounts and property valued below the current lifetime estate tax exemption amount or who have already set up a trust, naming a revocable living trust as the beneficiary of a life insurance policy can be a useful option. Doing so simply adds the death benefit from the life insurance policy to what you already have in trust, payable only to the trust’s beneficiaries according to the instructions already in the trust agreement. The benefit of this approach is that it instantly coordinates your life insurance proceeds with the rest of your estate plan.

Irrevocable Life Insurance Trust

ILITAn irrevocable life insurance trust is an added layer of protection because it can both own the life insurance policy and be named as the beneficiary. You can create an irrevocable life insurance trust either by transferring ownership of an existing policy into the trust or by the trust purchasing a new policy. Using your annual gift tax exclusion, you make cash gifts to the trust to pay the insurance premiums. Upon your death, the trust receives the death benefit and the trustee distributes the money according to the instructions in the trust document. This strategy also allows you to remove the value of the life insurance policy and the death benefit from your taxable estate.

Life insurance policies come with a broad range of options because families and individuals have an endless variety of circumstances. Insurance professionals, with financial advisors and estate planning attorneys, can help navigate the options and identify solutions to achieve the ultimate goal – peace of mind.

Those having questions and needing assistance with their estate plan, may contact me at amanda.dorio@henlaw.com or by phone at 239-344-1362.

 

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