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.
THE TOP TEN LIFE INSURANCE
BENEFICIARY MISTAKES TO AVOID ARE:
1. NAMING A MINOR CHILD
Life insurance companies will not pay the proceeds directly to minors. If you have not created a trust or made any legal arrangements for someone to manage the money, you will need the court to appoint a guardian, which is an expensive process, to handle the proceeds until the child reaches 18 or 21, depending on the state. Guardianships in California require an annual formal accounting, which is costly.
Instead, you can leave the money for the child’s benefit to a trusted adult; set up a trust to benefit the child and name the trust as the beneficiary of the policy; or name an adult custodian for the life insurance proceeds under the Uniform Transfers to Minor Act. Consult an estate attorney to decide the best course.
2. MAKING A DEPENDENT INELIGIBLE
FOR GOVERNMENT BENEFITS
Naming a lifelong dependent, such as a child with special needs, as beneficiary puts the loved one at risk for losing eligibility for government assistance. Anyone who receives a gift or inheritance of more than $2,000 is disqualified for Supplemental Security Income and Medicaid, under federal law.
Work with an attorney to set up a special needs trust, and name the trust as beneficiary. A trustee you appoint will manage the money for the dependent’s benefit.
3. OVERLOOKING YOUR SPOUSE
IN A COMMUNITY-PROPERTY STATE
Generally you can name anyone with whom you have a relationship as beneficiary. However, in community-property states your spouse will be required to execute a spousal waiver form waiving rights to the money if you designate anyone else as beneficiary. Community-property states are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.
4. FALLING INTO A TAX TRAP
Life insurance death benefits are generally tax-free – except when three different people are the policy owner, the insured, and the beneficiary. In that case, the death benefit could count as a taxable gift to the beneficiary. For example, if a husband owns a life insurance policy on his wife’s life and names their adult son as beneficiary, the husband is creating a gift of the policy proceeds to his son. The person who makes the gift would be subject to the tax, if the amount of the gift exceeds federal limits, which are currently $14,000.00
This problem can be avoided in most cases by having the wife own the policy, insuring herself. However, the situation may be problematic in community-property states. Consult a financial adviser to decide the best way to structure the policy.
5. ASSUMING YOUR WILL TRUMPS THE POLICY
A life insurance policy is a contract. Regardless of what your last Will says, the life insurance money will be paid to the beneficiary listed on the policy. Contact your insurer to change your beneficiary if needed.
6. NEGLECTING TO UPDATE
I recommend that you review your policy every two years and after major life events, such as divorce, death, marriage, re-marriage, a new birth or adoption. Change the beneficiaries when circumstances change. Unfortunately, many people forget to do so and leave an ex-spouse listed as the beneficiary or an individual who is predeceased.
7. OVERLOOKING THE DETAILS
Be specific when you name beneficiaries. Instead of “my children,” list their names, Social Security numbers and addresses. When naming multiple beneficiaries, decide whether you want the money divided “per stirpes,” which means by branch of the family, or per capita, which means by head.
8. NOT TELLING ANYONE
It is important to tell someone that you have a life insurance policy, where it is and how to find it. Better yet, put a copy of the policy or at least the declaration and beneficiary pages into your Estate Planning Binder and complete the Estate Planning Data Recorder and give a copy to your attorney. If you need a copy of this form, please contact me and I’ll be glad to provide it to you at no cost.
9. GIVING MONEY WITH NO STRINGS ATTACHED
Naming your young-adult children as beneficiaries without setting any conditions for how the money is dispersed can be a setup for financial failure. One way is to set up a trust with specifics for how the money can be released and what it can be used for until the young adult reaches a certain age. Insurers are beginning to introduce policies that let you arrange for the death benefit to be paid out in installments.
10. NAMING ONLY A PRIMARY BENEFICIARY
Most people name only their spouse beneficiary, but do not consider the spouse might predecease them. With spouses traveling together on joint vacations, the possibility that something would happen to you and your spouse together is realistic.
When there is no living beneficiary, the life insurance benefit typically goes into the estate and is subject to probate. Heirs may face a long wait to get the money and the life insurance proceeds are now subject to creditor claims and demands. I recommend naming secondary and final beneficiaries. If the primary beneficiary predeceases you, then the money passes to the secondary beneficiary. If the secondary beneficiary has passed away when you die, then the death benefit goes to the final beneficiary. If the estate is the beneficiary of life insurance, the proceeds are no longer “creditor free,” which is one the biggest benefits of life insurance. If the estate is the beneficiary of the life insurance, then the life insurance proceeds are added to the estate. All of the estate is subject to creditor claims.
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.
OWNERSHIP BY SPOUSE
Years ago, when the marital deduction was limited, there was some advantage in having the spouse own the policy. This does not accomplish much under current law, and to the extent the spouse is a beneficiary, taxes will be deferred until the spouse’s subsequent death. This defers but does not eliminate the estate tax problem.
OWNERSHIP BY CHILDREN
Ownership by children or other family members can eliminate the estate tax, but it may also defeat some nontax objectives (such as spendthrift protection) and some tax objectives (such as generation-skipping). The primary problem is loss of control with respect to the use and application of the insurance proceeds. Untimely deaths, lawsuits and other creditors’ claims, and even divorces can make the insurance proceeds unavailable for their intended purposes.
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.