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Important Considerations for Beneficiary Designations of Life Insurance Policies

Life insurance is often one of the most important parts of an estate plan. People usually purchase life insurance to prevent their spouse, children, or other dependents from suffering financial hardship if they die unexpectedly.

You may think that all you need to do is simply write in the name of the person you would like to receive the proceeds from your life insurance policy on the beneficiary designation section of your paperwork and forget about it. However, there are several important factors you should consider first.

Consider Naming a Trust as the Beneficiary

Many people designate the person they would like to benefit as a direct beneficiary of their life insurance policy. If you want to provide funds for your spouse’s retirement, it may make sense to name him or her as the primary beneficiary. However, depending upon your particular circumstances, goals, and who you are trying to protect, it may be more prudent to name a trust as the beneficiary. For certain individuals, it will be more beneficial if the life insurance proceeds are distributed according to the terms you have established in your trust rather than having a large cash payment made directly to them.

Minor children. Life insurance companies will not pay death benefits to children under the age of 18 (or the age of majority in your particular state). As a result, if you name your child as a primary beneficiary, but die when your child is still a minor, a court-appointed guardian, who may or may not be someone you would have chosen, will likely be put in charge of managing the payout of the insurance proceeds for your child’s benefit. The proceeds may not be managed in the way you would have chosen. In addition, any remaining proceeds will likely go directly into their pockets when your child becomes a legal adult--whether they are mature enough to handle such a windfall. This can be avoided if a trust is named as the primary beneficiary of the life insurance policy, with your child as a beneficiary of the trust. Then, the life insurance proceeds will be managed by the person you have chosen as the trustee and will be distributed to your child according to your wishes.

Some people may also mistakenly designate the child’s caretaker as the primary beneficiary to avoid the appointment of a guardian. However, this does not guarantee that the funds will actually be used for the child’s benefit, and the proceeds are vulnerable to claims made by the caretaker’s creditors. These problems can be avoided by designating a trust as the primary beneficiary and naming someone you trust as the trustee of that trust.

Recipients of government benefits. Although your intentions may be good, naming someone who is receiving need-based government benefits as a primary beneficiary of your life insurance policy may cause them to lose their eligibility for those benefits. A special needs trust can be created and named as the primary beneficiary of your life insurance policy. In that way, the insurance proceeds will be managed and distributed in a manner that will not compromise the government benefits, but will instead supplement them.

Beneficiaries who may be spendthrifts. If you are concerned that the potential beneficiary of your insurance proceeds is not financially responsible, making them a primary beneficiary may be asking for trouble. The proceeds could quickly be squandered. If you make a trust the primary beneficiary of your life insurance policy, and name the individual as the beneficiary of the trust, you can establish specific conditions for distributions to that person, for example, that the distributions must only be for health, maintenance, or educational purposes.

Think About Asset Protection

Designating a trust as the direct beneficiary of your life insurance policy can also protect its cash value and death benefit from creditors’ claims.

Protection against your creditors. All 50 states and the District of Columbia have statutes that protect the death benefit or cash value of life insurance, and sometimes both, from you and your estate’s creditor claims. In some states, however, the exemptions for cash value life insurance are limited to a specific dollar amount or to the amount reasonably necessary to support a beneficiary. In addition, although typically the death proceeds of the life insurance policy are never available to your creditors because they pass to your beneficiaries without ever becoming part of your estate, some states have laws that limit the exemption only to certain beneficiaries, such as a spouse, children, or other dependents. Designating a special trust called an irrevocable life insurance trust (ILIT) as the primary beneficiary of your policy can be a strategy to protect proceeds that are outside the scope of the statutory exemption.
In addition, keep in mind that it is essential that you actually name a beneficiary or beneficiaries for your life insurance policy, because if you do not and leave this designation blank, the proceeds of the life insurance policy will be payable to your estate by default. Because your estate is responsible for paying off your debts, the life insurance proceeds may be available to satisfy your creditors’ claims, and the individuals you want to benefit may never see a penny of it. On the other hand, you may choose to do this intentionally, to ensure that your estate has sufficient funds to pay off your debts. If your main goal is to provide for the needs of your family, however, you need to name them or a trust created for their benefit as the beneficiary of the policy.

Protection against your loved ones’ creditors. If your spouse is the primary beneficiary of your life insurance policy, the proceeds typically cannot be reached by your individual creditors. However, if your spouse has joint debts or obligations with you, for example, if he or she co-signed a mortgage loan, credit card, or personal loan with you, the proceeds may be available to creditors to satisfy those obligations, depending upon state law.

Also, it is important to keep in mind that although state law provides that the proceeds of your life insurance policy are exempt (at least partially) from your creditors, once those proceeds are in the hands of your direct beneficiaries, they typically are within the reach of their creditors. Even if your children or other loved ones do not currently have any creditors, they may eventually face lawsuits, bankruptcy, or divorce. If they are primary beneficiaries of your life insurance policy, the death benefit you intended for them to receive may be exposed to claims from those creditors.

An ILIT or other trust can also protect the death benefit through the inclusion of a “spendthrift trust” provision that prohibits trust beneficiaries from pledging the trust assets, including life insurance proceeds, as collateral. Their creditors are then only able to reach any distributions made to them from the trust.

Seek Advice About the Amount Your Beneficiaries Will Need

Seek the counsel of your financial advisor to determine the amount of life insurance benefits your loved ones will need for a financially secure future. Many factors should be taken into account, including your current income, other insurance policies, savings and investments, possible college and other future expenses, your total debt, including your mortgage, as well as the number of individuals who are financially dependent on you. It is important to establish a secure safety net, as well as provide financial stability during the transition period after your death, particularly if you are the primary breadwinner, and your spouse is the main caregiver for your children but will need to return to the workforce.

We Can Help

It is important to check with us, as well as your financial advisor, to make sure that you have covered all the bases when it comes to life insurance policies and beneficiary designations. We can help you decide how to best protect your loved ones if you pass away by carefully considering who you should name as your beneficiaries, including whether it would be advantageous for a trust to be the primary beneficiary, and how much insurance to acquire. If you already have a life insurance policy, we can also provide guidance as you review and update your beneficiary designations. We look forward to helping you gain peace of mind by ensuring the financial security of your family.