Life insurance has many advantages. One advantage is the beneficiary receives the death benefit free from income tax. Another advantage is that the death benefit money passes directly to your beneficiary, outside of the probate process. While that is great, it underscores the importance of beneficiary designations. Naming the wrong beneficiary creates problems and potentially expensive solutions to fix. In this article, we discuss proper beneficiary designations and common beneficiary designation mistakes.
What Is A Beneficiary And Who Can Be One?
A beneficiary is simply a person or entity who receives money, in this case a death benefit, from a life insurance contract, upon the death of the insured.
While you may think you can have anyone as a beneficiary, you can’t. A beneficiary must have an insurable interest.
What is insurable interest? It means that person or entity, as a beneficiary, would face financial hardship upon your death.
That means a beneficiary can’t be a stranger or some unknown person. Common beneficiaries with insurable interest include:
(1) yourself – but we don’t recommend as noted below
(2) your spouse
(3) your ex-spouse
(4) your children
(5) parents or grandparents
(6) other close relatives
(7) a fiancé (but usually not a boyfriend/girlfriend)
(8) a business
(9) Anyone with demonstrated hardship upon your death (i.e. a personal loan you made)
(10) a charity with demonstrated previously donation or connection
If you include a person without a clear insurable interest, you will have to prove that to the insurance carrier. For example, if you financially take care of your second or third cousin, while this is a relative, you may need to prove that insurable interest.
Many Beneficiary Designation Mistakes
Does naming a beneficiary seem easy? In many cases, it is. However, there are endless mistakes people make with their beneficiary designation. Here are some of them.
We commonly make our children the beneficiary of our life insurance policies. Why not? An insurable interest exists. The problem is many carriers won’t issue the death benefit to a minor child. Do you really think a 10-year-old or a 15-year-old knows how to manage money? This is a common beneficiary designation mistake. One we see often.
A better solution is to include your spouse as primary. If this is not possible, then set up a trust for the child the beneficiary. Additionally, you can name a reliable adult to manage the money, such as a brother or sister.
Honestly, a trust, in our opinion, is probably the best choice. A trust is a separate entity, created under law. Upon your death, the trust receives the death benefit proceeds and will disburse the money to your child per the terms of the trust – terms that you specify. We advise you to contact a knowledgeable estate planning attorney regarding specific questions.
A Person Who Has No Financial Sensibility
Upon our death, we want to provide our loved ones with financial security. It is a normal feeling.
Sometimes, our loved ones simply have no financial sense. They spend more than they save. They have trouble saving money or they work paycheck-to-paycheck. Yes, there is one in every family. And, yes, I know you agree with me.
Is it sensible and responsible to name these people as a beneficiary? Think about how they would act if they received a $500,000 or $1,000,000 income tax-free death benefit proceeds? This money is to replace the current and future income lost due to your death, not to go on a Tiffany’s shopping spree.
If your spouse or close family member would spend the money like water, the best choice, as we identified above, is to create a trust. You can specify the terms of the trust. There are provisions known as spendthrift. These provisions impose limits on money issued to him or her.
A Special Needs Child Or Adult
Children or adults with special needs are eligible for government benefits assuming they meet income and asset limits. These limits depend on the state of residence. Generally, however, the income limit is $2,000 and no more than $3,000 in assets in the person’s name. If they have anything higher, they will be disqualified.
You and your relatives might think they are doing this person a favor and naming them as a beneficiary. Any proceeds from life insurance will likely disqualify them for needed government benefits. Worse, some states may disallow them from reapplying for a certain number of years.
A specially designed trust, called a supplemental needs or special needs trust, is a solution to this issue. Like in the examples before, the trust receives any money for the benefit of the special needs person. Consult an experienced attorney specializing in this area of the law for more information.
Not Changing An Ex-Spouse
Divorce is a major life change when it comes to beneficiary designations and life insurance. If you do not update your beneficiaries upon divorce, the proceeds on your death benefit may inadvertently go to your ex-spouse. For example, you divorce your husband and remarry. You never changed your life insurance. Upon your death, your proceeds benefit your ex-wife, not your current wife. However, even more problems arise as we discuss below.
If you have a divorce settlement or divorce decree, and it requires you or your ex-spouse to continue the life insurance (as the insured), the beneficiary designation can change from a spousal designation to an ex-spouse or related family member designation. Why important? It depends on your state’s divorce and estate laws. True story: We received a call from a woman who divorced her husband years prior. For one reason or another, the life insurance policy never updated. He was the owner and insured. She was the primary beneficiary. Without getting into the details, he became uninsurable.
The insurance plan in place was the best option for any life insurance. The ex-wife never changed her from spousal designation to related family member. As such, upon his death, a legal battle ensued with the carrier as the carrier sought to determine if the ex-spouse or the man’s estate receive the proceeds. Don’t make the same mistake. If you have a divorce decree or settlement paperwork, make sure the beneficiary designations are changed accordingly.
Not Adjusting With Every Family Change
Family dynamics change often. Yearly, even. With every death and birth, you want to check your beneficiary designations. Why? Here is an honest mistake. Parents buy a life insurance policy on the life of their son, the parents are the beneficiary. Son is now 40, married, with kids. He owns the policy outright now. He is the owner and insured. His parents are still the beneficiary. Son dies unexpected, and the parents…not his wife or kids….receive the death benefit money. Let’s hope the in-laws get along!
Another easy miss is when someone remarries. An insurance policy may list the ex-spouse as a beneficiary. As mentioned before, this is a problematic situation.
Not Being Specific
Sure, it is easy that you want to leave your death benefit proceeds to your “children”. What if you remarry with a stepchild? According to your life insurance beneficiary designation, your stepchild will also receive money. Is that your intention? Maybe. An easier solution is to simply specify who, by name, with birthdates and social security numbers if possible.
Naming Yourself Or Estate As Beneficiary
As mentioned earlier, a major advantage of life insurance is that the money passes free from probate. However, if you name yourself as beneficiary, you just destroyed this awesome estate planning tool. Instead of passing outside of the probate process, the life insurance money remains a part of the probate process. Moreover, the courts could take a year or longer to release the money. Finally, probate costs consume the life insurance death benefit money. Ultimately, your beneficiaries will have much less than if you simply named them a beneficiary on your life insurance policy in the first place.
Take the time to review your beneficiary designations. Do you feel confused? Take advantage of our free beneficiary designation audit service. Would knowing how your money will end up and who will receive the life insurance money beneficial to you? We can work with you to determine if your beneficiary designations are aligned with your goals, intentions, and values. This is a complimentary service. Feel free to contact us if you have any questions or use the form below to get in touch with you. We will contact you promptly and as always, we keep your best interests first and foremost.