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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.

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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 thousand dollars.

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 tax.

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 tax laws.

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

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