Editor’s note: This article first appeared on Insure.com and is reprinted here with their permission. Click here for the original post.
Naming who should get the life insurance money after you die sounds simple, but designating beneficiaries can get tricky.
Mistakes are common, financial advisers say — and they can be heartbreaking and expensive.
When mistakes are made “you’re not creating problems for you,” says Keith Friedman, principal of FBO Strategies, an estate planning and insurance firm in Stamford, Conn. “You’re creating problems for the people you leave behind.”
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Here are 10 life insurance beneficiary mistakes to avoid.
1. Naming a minor child
Life insurance companies won’t pay the proceeds directly to minors. If you haven’t created a trust or made any legal arrangements for someone to manage the money, the court will appoint a guardian — a costly process — to handle the proceeds until the child reaches 18 or 21, depending on the state.
Instead, you can leave the money for the child’s benefit to a reliable 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, even a secret lover.
“Life insurance is not a judge of someone’s morals,” Friedman says.
However, in community-property states, your spouse typically would have to sign a form waiving rights to the money if you designate anyone else as beneficiary. Community-property states are:
- New Mexico
4. Falling into a tax trap
Life insurance death benefits are generally tax-free — except when three different people play the roles of policy owner, the insured and the beneficiary. In that case, the death benefit could count as a taxable gift to the beneficiary, says Amy Rose Herrick, a Chartered Financial Consultant and life insurance agent with offices in the U.S. Virgin Islands and Tecumseh, Kan.
Say, for instance, a wife owns a life insurance policy on her husband’s life and names their adult daughter as beneficiary. The wife effectively is creating a gift of the policy proceeds to her daughter, Herrick says. The person who makes the gift — the wife — is the one who would be subject to the tax, if the amount of the gift exceeds federal limits.
The problem could be avoided in most cases by having the husband own the policy, insuring himself. However the situation can get tricky in community-property states. Consult a financial adviser to decide the best way to structure the policy.
5. Assuming a will trumps the policy
A life insurance policy is a contract. Regardless of what your will says, the life insurance money will be paid to the beneficiary listed on the policy. That’s why it’s important to contact your insurer to change your beneficiary if needed.
See more information on wills vs. life insurance policies: Who’s the boss?