Who will you name? Picking your beneficiary
OK, you're finally getting around to buying life insurance
so your loved ones will be protected if something happens to you.
While you're at it, you'll want to take a few minutes
to think through who (or what) the beneficiaries of the policy will
be. A beneficiary is the person or entity that receives the proceeds
of the policy when the insured person dies.
Naming an appropriate beneficiary is critical to ensuring
that your estate is distributed as you intended, and that your heirs'
tax burden is minimized. Depending on how you set it up, for example,
the proceeds of your insurance policy may be included in your estate
-- boosting the amount of estate taxes your heirs have to pay.
Most people name either a person, such as a
responsible family member or friend, or a trust as the beneficiary
of their life insurance policies. A trust is a legal device in which
property is held by one person or entity for the benefit of another.
Each has pros and cons.
Naming a person
Some people, particularly those with smaller estates, may decide
to name a person as the beneficiary of their insurance policy. For
instance, many husbands and wives with children name each other
as beneficiaries. Should one spouse die, the other will receive
the proceeds of the policy and can use it to support themselves
and their children.
Naming a person is easy and doesn't cost anything.
In contrast, setting up a trust can cost several hundred to several
On the other hand, naming a person as a beneficiary
has several drawbacks. Most significantly, if a person is the beneficiary,
the proceeds will be included in your estate. That can bump up its
value so that your heirs end up paying estate taxes, which can consume
between 45 and 55 percent of your estate. Of course if your estate
is worth less than $1.5 million, you don't have to worry about this.
There are some exceptions to the estate tax laws.
Currently, one spouse can leave his or her estate, including insurance
proceeds -- no matter its size -- to the other, and the spouse won't
have to pay estate taxes. "There's an unlimited marital deduction
at the federal level," says Dave Evans, vice president with
the professional association of Independent Insurance Agents and
Brokers of America, in Alexandria, Va. Still, some states, such
as Ohio, Indiana and Pennsylvania, impose an inheritance or estate
A couple can only use this deduction once, says Evans.
So, if you're a surviving spouse, you'll want to consider whether
you should use the exemption and whether your estate eventually
will grow to the point that your heirs may have to pay estate taxes.
For 2004, the portion of any estate exceeding $1.5
million is subject to federal estate taxes. While this is a lot
of money, it can be easier to reach than it sounds -- especially
if your life insurance proceeds are included in the estate total.
Under current tax regulations, the amount excluded
from estate tax calculations gradually increases to $3.5 million
in 2009. The tax is completely repealed in 2010, and then is reinstated
in 2011 for amounts above $1 million. If you can reasonably expect
to live until 2011, you'll want to consider how much your estate
might grow between now and then.
Here's another issue to think about if you name a
person as the beneficiary: You'll need to identify one or more contingent
beneficiaries. A contingent beneficiary receives the proceeds of
the policy if the primary beneficiary, or the beneficiary named
first, is dead when the insured person dies. The contingent beneficiary
can be a trust or a person.
Trusts as beneficiaries
For many people, it makes sense to name a trust,
rather than a person, as the primary beneficiary of a life insurance
policy. One type of trust often used is what's known as an "Irrevocable
Life Insurance Trust," or ILIT. "The irrevocable trust
owns the policy and is the beneficiary," says Michael Tessler,
president of Brokerage Unlimited Inc., in St. Louis. "Then,
the policy is not included in the person's taxable estate."
The benefits of an ILIT can be especially meaningful
if you're a single parent with young children. That's because you
can't name your children as beneficiaries. By law, minor children
can't own property -- yet you'll want to know that the proceeds
will be available to them.
If you have a special-needs child of any age, you'll
also want to consider a trust, says Susan Calomino, CFP, with Lincoln
Financial Advisors in Chicago. "Set up a trust with a trustee
to manage the money for your child." This helps in two ways.
First, your child won't be put in a position of having to manage
money when he or she isn't able to. In addition, if your child were
to receive the proceeds from a life insurance policy, it could reduce
his or her ability to obtain governmental assistance.
Another benefit of using a trust: Trustees are legally
obligated to spend the money from the policy with the best interests
of the beneficiary in mind, says Tessler. "They have to act
as the (trust) document says."
Still, ILITs don't come without problems. As the name
implies, the trusts are irrevocable. In addition, naming a trust
as the beneficiary requires an investment of time and money. Drawing
up the trust documents typically runs between $750 and $1,500, says
Kay Shirley, Ph.D., CFP and president of Financial Development Corporation
in Atlanta. You also need to set up a checking account in the name
of the trust, and pay the insurance premiums from the account.
If you decide to use an ILIT, you'll typically want
to establish it first, and then have the ILIT itself purchase a
life insurance policy, says Calomino. That's because if you already
own a life insurance policy and transfer it to the trust, you'll
have to contend with a 36-month look-back period. In other words,
if you die within three years after having purchased the policy,
the death benefit is considered part of your estate.
Another option is a testamentary trust, says Calomino.
A testamentary trust only is created at your death, so there are
no upfront or ongoing costs to establish and maintain the trust.
"You can have a simple will with a contingent testamentary
trust. That way your kids won't receive the assets, but will have
access to the income," Calomino says. You can set up the trust
so that a trustee manages the funds and provides for your children's
support and education.
Mistakes to avoid
As you think about naming a beneficiary, you'll
want to avoid several mistakes that financial advisers see all too
frequently. First is naming the estate itself as the beneficiary.
If you do that, the death benefit is included in your estate, which
can boost the estate taxes owed. It also means that the proceeds
will be subject to probate, says David Woods, president of the Life
and Health Insurance Foundation for Education in Washington D.C.
Probate is the legal process by which a will is proven genuine.
Another mistake is assuming that the proceeds from
a life insurance policy will be distributed according to your will.
If your will mentions your insurance policy and identifies a beneficiary
differing from the one listed on the policy, the proceeds still
will go to the person or entity named on the policy.
Finally, you don't want to put your policy in the
drawer and forget about it. For one thing, the tax laws may have
changed by the time a claim is made on your policy. You'll want
to regularly review your policy and make sure it reflects current
And, any time you experience a significant change
in your personal life, such as a divorce, birth or death, you'll
also want to review your life insurance coverage and beneficiaries.
Nearly all financial planning professionals can recall instances
where a couple divorces and one of the former spouses remarries,
but neglects to list his or her new mate as the beneficiary of a
life insurance policy.
-- Posted: July 28, 2004