January 28, 2015

Reviewing Your Life Insurance

In Financial Planning, Insurance

10 Potential Pitfalls and How to Protect Your Beneficiaries

1) Naming a Minor Child

Insurance companies will not pay the proceeds of a life insurance policy directly to a minor. Absent a trust or other specified legal arrangement, a court-appointed guardian will handle all proceeds until the child reaches legal age (18 or 21, depending on the state).

There are three ways to avoid this scenario: (1) Leave the money to a reliable adult specifying that it is for the child’s benefit (2) Set up a trust for the benefit of the child and name the trust as the policy beneficiary or (3) Name an adult custodian for the life insurance proceeds under the Uniform Transfers to Minors Act. You should consult with an estate attorney to decide which option is the best course of action for you.

2) Accidentally Making a Dependent Ineligible for Government Benefits

Naming a lifelong dependent as beneficiary, such as a child with special needs, might make that loved one ineligible 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.

The solution here is to work with an attorney to set up a special needs trust, and name the trust as beneficiary, with a trustee, appointed by you, to manage the money for the dependent’s benefit.

3) Overlooking Your Spouse in a Community Property State

Generally, you can name as beneficiary anyone with whom you have a relationship, including children, non-spousal relatives, significant others, even a friend. In community property states, if you designate anyone other than your spouse as beneficiary, your spouse typically has to sign a form waiving his/her rights to the proceeds. Without a spousal waiver, your specified beneficiary, even your child, could see proceeds held up in court. If the surviving spouse receives the insurance benefit through court order, and wishing to comply with the beneficiary designation then gifts the money to the beneficiary, a potentially large tax burden could result.

You should understand the laws in your state and do your best to remove impediments from the life insurance payment process.

4) Falling Into a Tax Trap

Death benefits are generally tax-free. An exception occurs when the policy owner, insured, and beneficiary are three different people, in which case the death benefit could be deemed a taxable gift to the beneficiary.

In most cases, you can avoid this scenario by having the insured own the policy. Consult a financial advisor to decide the best way to structure your policy given the laws of the state in which you live.

5) Assuming Your Will Trumps the Policy

A life insurance policy is a contract, legal and binding. It exists—and is enforced—separate from your will. The insurance company is required by law to pay the beneficiary you specified on your policy, even if your will specifies differently.

Work with your estate planning attorney and financial advisor together to avoid potentially damaging discrepancies.

6) Forgetting to Update

Review your policy every three years and after any major life events (marriages, births, deaths, divorce). When life circumstances change, you should change your beneficiary accordingly.

7) Neglecting Details

Be specific when you name beneficiaries. Instead of ‘my children’, list names, addresses, and Social Security numbers. In the case of 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. Failure to be completely specific in either of the above ways could lead to higher administration costs, delays, or payments which do not match your intentions.

8) Failure to Report

Do not keep a secret life insurance policy, either intentionally or unintentionally. Beneficiaries should know that you have a policy, where it is and how to find it. Failure to communicate now could lead to chaos later. Worst case scenario, the benefits are never collected.

If you have living benefits on your insurance and develop dementia, the person with your durable power of attorney will need to make the claim. Make sure that person is aware of the policy, where it is, how to find it and what it can do.

9) Naming Only a Primary Beneficiary

Often, a spouse is named is the primary—and only—beneficiary. The spouse may predecease the policy owner, in which case the policy owner should update the beneficiary designations (see 6, above). Another scenario involves the spouse and policy owner dying together. In either of the above cases, the policy would be left without a beneficiary, causing uncertainty, delay, and possible loss, as life insurance benefits normally protected from creditors are exposed when left without a beneficiary.

Most professionals advise naming primary, secondary, and final beneficiaries.

10) Giving Money with No Strings Attached

Naming young adult children or other financially unsophisticated persons as beneficiaries without setting any conditions on how the money is dispersed can lead to financial failure.

A trust, established with detailed instructions for the proceeds, can help solve this problem. So can policies, currently available from many insurers, which pay the benefit in installments. Often with this type of policy you can leave an upfront, initial sum of whatever size you choose, and specify that the rest be paid out in installments over any number of years you desire. These policies can usually be altered by the policy owner while he/she is alive, but are unchangeable by the beneficiaries after the policy owner’s death.

We buy life insurance to make life easier for our loved ones, to provide for them, not to burden them with complication, costs, court battles, or additional tax burdens. Work with legal and financial professionals when you buy life insurance to ensure that you and your beneficiaries derive the intended benefits of your generosity.

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