So you’ve made the responsible decision and purchased a life insurance policy to ensure your dependents will be cared for in the unfortunate event something happens to you. Naming a beneficiary should be the easy part, right? But mistakes made when choosing your beneficiary can lead to unforeseen consequences.
When a mistake happens, it can mean added difficulty, stress, and a financial burden on those you intended to benefit. Below are 5 of the most common mistakes made when choosing a life insurance beneficiary.
1. Naming a minor child.
While an adult beneficiary will receive funds outright, life insurance proceeds will not be paid directly to a minor. Instead, the court will have to appoint a guardian to manage the funds until the child reaches the age of majority. Going through guardianship proceedings can be costly, especially if they are contested. Designating a guardian for minor children in your will does not solve the problem either – the court will have to ultimately appoint someone to act on behalf of the minor.
The better alternative is to establish a trust as beneficiary of the policy and to name a trusted adult or financial institution to manage the funds on behalf of your child.
2. Naming your estate.
Designating your estate as beneficiary of a life insurance policy reduces some of the benefit of holding the policy. Funds will have to be transferred to your heirs through probate with court oversight, meaning a longer wait, and will be subject to any outstanding claims from creditors as well as taxes and fees.
3. Naming young-adult children.
Life insurance proceeds will be paid to an adult child beneficiary without taxes, fees, oversight, or direction as to how funds can be used, meaning they can be spent immediately on anything. In addition, the funds will count as an asset for FAFSA purposes, meaning a potential loss of eligibility for student loans. Adult children with special needs could also lose eligibility for government assistance from SSI and Medicaid.
Again, the better alternative is to establish a trust for the benefit of your adult child. Funds can be used for education, living expenses, and anything else designated by the trust or in your trustee’s discretion. However, trust assets will not be considered for FAFSA purposes and can avoid the loss of government assistance programs.
4. Naming only one beneficiary and/or forgetting to update your beneficiary.
You have the option to name several backup beneficiaries to plan for every contingency. If your primary beneficiary pre-deceases you, don’t let the payout go through probate! See #2 above.
If you go through a divorce or have another significant life event, you should double-check your policies and update your beneficiaries. A designated beneficiary on your policy will always trump whatever else is in your estate plan. Even if you’ve been divorced, if your ex-spouse is named on the policy, they will receive the benefit.
It’s a good idea to double check your beneficiary designations every 3-5 years to make sure they are up to date. You should provide as many details as possible for each beneficiary including their SSN, address, and contact phone numbers.
5. Increasing your tax burden.
If the insured, policy owner, and beneficiary are three separate people, then any payout could be subject to gift taxes. In such an instance, the policy owner would be taxed for making a gift, if the policy amount exceeds federal limits.
This issue can be avoided by making sure the insured is also the policy owner in most instances. In some cases, usually involving divorce or child support, the policy owner and insured will be different parties. In those cases it may be advisable for the policy owner to keep themselves named as the beneficiary, if allowable under the order.
Life insurance is an important aspect of any estate plan so take the time to learn about your options and ensure your resources reach your intended beneficiaries. For an estate plan evaluation contact Melone Hatley in our Northern Virginia office at 703-995-9900 and in Virginia Beach at 757-296-0580.
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