THE TEN MOST COMMON MISTAKES
Naming who should get the life insurance money after you die sounds simple, but designating beneficiaries can be complicated. Mistakes are common and can be expensive. Now that you have read “Naming Life Insurance Beneficiaries and The Ten Most Common Mistakes, Part 1,” just whom should you name as beneficiary?
WHO SHOULD THE BENEFICIARY BE?
HERE ARE SOME OPTIONS:
1. Name the person whom you presume would be the guardian of your minor children. This is a very bad idea. By naming a third party to directly receive funds on behalf of your children, you are creating a moral obligation that the individual will actually apply the funds for the benefit of your children. Even if the individual told you now that he or she would do just that, such a promise is not enforceable. Additionally, that individual’s financial circumstances could be different at the time of your death and he or she could using the money for any purpose they choose. The individual could be incompetent at the time of your death. That individual’s fiduciary (guardian or attorney-in-fact under a power of attorney) could have no idea of the prior moral agreement. Even if they did, their obligation would not be towards your children. On the other hand, even if the individual followed through by using the funds to provide for your children that could create gift tax complications for him or her, should any of your children receive more than $14,000.00 from your named beneficiary. In short, this arrangement is a very bad idea.
2. Name the minor children themselves as the beneficiaries. This is a better idea. However, no insurance company will issue a check payable to a minor. Thus, someone will have to petition the court on behalf of the minor(s) for the appointment of a guardian to receive and administer the funds for the minor’s benefit. This process is not quick and lengthy, costs attorney fees and court filing fees and also requires formal accounting annually, which is costly. In the meantime, the insurance company does not distribute the funds and they are not available for the support of the children. When the child turns 18, the remaining insurance money is his or hers. Thus, although it is better to name your minor children as the beneficiaries of life insurance, it is not the best idea.
3. Name the Trustee of the testamentary sub-trust which you have created for your children’s benefit under your Last Will. This is the best idea. If you have minor beneficiaries, the beneficiary designation can read, “100 percent (100%) payable to Jack Roe, Trustee in the Last Will and Testament of the insured or his successor(s) in trust for the benefit of Jane Doe and John Doe, minor children of the Insured. LIFE INSURANCE PROCEEDS. My trustee shall collect the proceeds of any life insurance policy for which my trustee is the beneficiary, and shall hold those proceeds under the terms of this instrument. Payment to my trustee shall be a full discharge of the insurance company on account of the policy, and the insurance company shall not be responsible for the proper discharge of the trust. My trustee has no duty to begin collection proceedings or litigation to enforce payment of any life insurance policies until reasonable provision has been made to indemnify my trustee for all anticipated expenses and liabilities. Any proceeds of life insurance, retirement benefits, annuity payments or other benefits which are made payable to the Trustee named in this Will shall be allocated to the specific sub-trust indicated in the beneficiary designation, or if none, as if the proceeds or benefits had been a part of my estate at the time of my death.”
This trust is a testamentary “sub-trust” because it is created under your Will and upon your death. By having the Trustee receive the money directly, the Trustee can immediately apply the money for the benefit of your children according to the directions you have provided to the Trustee in your Will. In your directions, you can also select how old your children will be when their trust comes to an end. In most cases, I recommend to clients that it be at the age of 30. This way the Trustee can make sure the children get through college and hopefully the children are much more mature than they were the age of 18.
4. You should also consider and discuss with counsel if it is appropriate to create an Irrevocable Life Insurance Trust. Please see the article, “Naming Life Insurance Beneficiaries and The Ten Most Common Mistakes, Part 1” and the One Final Though to Consider section.
You may name multiple beneficiaries if you choose. The only requirement is that they must all have an insurable interest in you (e.g., spouse, child, business partner, etc.) at the time you apply for the insurance.
If you name multiple beneficiaries, you must also specify how much each beneficiary will receive. You may not want to give each beneficiary an equal share, so you must state how the proceeds should be divided. Because of the numerous interest and dividend adjustments the insurance company must make, the death benefit check often does not equal the policy’s face value. Thus, it’s wise to distribute percentage shares to your beneficiaries, or to designate one beneficiary to receive any leftover balance. If you name a lender or creditor (even if a family member or friend) and designate such on your application or indicate on your insurance application the purpose of the insurance is to “pay debt,” there may be serious legal consequences that you need to consider and discuss with counsel.
HOW DO YOU NAME OR CHANGE A BENEFICIARY?
The insurer will provide you with a beneficiary designation form at the time you apply for insurance coverage. Generally, you only need to list the names of the beneficiaries, sign the form, and date it. When changing a beneficiary, a similar form is used and most often is available for download electronically on the insurance company’s website. It is advisable to specifically revoke any previous designations by writing this in on the change of beneficiary form. Please see the article, “Naming Life Insurance Beneficiaries and the Ten Most Common Mistakes Part 1.”
WHY DESIGNATING THE PROPER
BENEFICIARY IS IMPORTANT?
Life insurance is purchased for two primary reasons: to create an instant estate to provide for your family members and to solve cash flow problems caused by your death. To attain these goals, you want to ensure that all the life insurance proceeds are received by the beneficiary. To do this, you need to avoid estate taxes that will deplete these funds. One way to avoid taxes is to properly designate the beneficiary.
SHOULD YOU NAME YOUR SPOUSE AS BENEFICIARY?
Most married people name their spouse as primary beneficiary. This may not always be a good idea. If your spouse is the beneficiary, then the proceeds pass free of estate taxes under the unlimited marital deduction, regardless of who owns the policy. However, if the spouse also has a sizeable estate, the proceeds will be included when he or she dies. You may only postpone estate taxes, not avoid them.
Additionally, if you and your spouse die simultaneously, the Uniform Simultaneous Death Act provides that the beneficiary will be presumed to have died first. This means that the unlimited marital deduction will be lost, and the proceeds will be included in your gross estate.
Be aware, however, that if you live in a community property state, your spouse must give written consent before you can designate anyone else as your beneficiary.
BE CAREFUL IF YOU NAME
YOUR ESTATE OR YOUR EXECUTOR
If your estate or your executor is named as beneficiary on your life insurance, the proceeds will be included in your gross estate for federal estate tax purposes. If your gross estate is large enough, estate taxes must be paid. These taxes reduce the life insurance proceeds available for your family, and the process of settling the estate will delay the availability of the insurance proceeds.
Of course, your child or spouse may also serve as your executor. In this case, he or she may be a perfectly appropriate beneficiary. Just make sure you indicate that the beneficiary is your child or spouse, and not just the executor of your estate.
BE CAREFUL IF YOU NAME A CREDITOR, OR SOMEONE
WHO WILL USE THE PROCEEDS TO DO YOU A FAVOR
Occasionally, a beneficiary is considered by the IRS to be for the benefit of your estate. When this happens, the proceeds from the life insurance policy are included in your gross estate for estate tax purposes. Examples of this include: naming a creditor as beneficiary (in payment of a debt); naming a beneficiary to receive proceeds under an agreement that requires him or her to pay your estate’s debts or expenses; or naming a beneficiary to receive proceeds to pay alimony or support. See the further cautions above.
YOU CAN’T NAME ANY BENEFICIARY
IF YOU ARE INCOMPETENT
If you are incompetent, you cannot name or change a beneficiary. You may be incompetent whether or not you are legally declared to be so. The test is similar to the test regarding wills.
DON’T NAME A MINOR UNLESS A GUARDIAN
HAS BEEN APPOINTED OR A TRUST IS USED
Insurers generally will not make settlements directly to minors. Do not name a minor as a beneficiary unless you also appoint a guardian or use a trust.
ONE FINAL THOUGHT TO CONSIDER AND DISCUSS
WITH COUNSEL: IRREVOCABLE INSURANCE TRUSTS
As discussed above, the proceeds of life insurance policies are included in the insured’s estate at his or her death if the insured had “an incident of ownership” in the policy within three years of death. Estate taxation can be escaped by having someone other than the deceased own the policy and all of its attendant rights.
IRREVOCABLE LIFE INSURANCE TRUST (ILIT)
An irrevocable trust can be made the owner and beneficiary of all life insurance, removing the proceeds from the estate of the insured and the insured’s spouse. The insured’s spouse can even be a beneficiary of the trust so long as contributions to the trust come from the insured’s separate property and other strict formalities are followed. Gifts of cash sufficient to pay policy premiums will usually be covered by the $14,000 annual exclusion for gift-tax purposes if the insurance trust contains the appropriate provision giving the trust’s beneficiaries a “Crummey power,” which is a right to withdraw trust contributions for a brief period of time, usually 30 days.
Since the policy will mushroom in value at death, the irrevocable insurance trust will exclude much more value from the taxable estate than the cumulative value of the annual-exclusion gifts.
As always, I appreciate your referrals and your business and look forward to working with you and showing you ways to protect and maximize your wealth and assets and discuss an irrevocable life insurance trust with you further.