What is a beneficiary? Perhaps the clearest definition comes from the Insurance Information Institute which states, “A beneficiary is a person or entity you name in a life insurance policy to receive the death benefit.” In other words, a beneficiary is a person or entity who will receive life insurance proceeds upon your passing.
Also included in the definition of beneficiaries are those who receive distributions from wills, trusts, annuities, or retirement accounts. But, we want to focus mainly on life insurance here since 52% of Americans own such a policy. More importantly, naming a beneficiary is a key component of a life insurance policy as it can protect the financial future of your loved ones.
The next question you’re probably asking is who can be named as your beneficiary? The short answer? Anyone.
Preferably, however, beneficiaries are often;
- Close family members, such as your spouse, children, or grandchildren
- Other family members like your siblings
- Your estate
- A trustee or trust that you’ve established
- Your business
- Your children’s guardians if they’re minors
- Charity or non-profit
You should, in general, think about whether those close to you will suffer financial hardship if you were to suddenly die when naming beneficiaries. What’s more, you can designate multiple people to be your beneficiaries. In thirds, say, between a surviving spouse and two children.
Overall, selecting beneficiaries, and keeping those choices up-to-date, is arguably the most important part of being a life insurance policy owner. And, to make sure that there aren’t any unintended or adverse consequences, here are ten beneficiary designation mistakes to avoid while you’re still alive. I mean once you’re gone, you can’t come back and rectify these errors.
1. Not naming a beneficiary.
Having no beneficiary named on your life insurance policy is probably the biggest and most glaring mistake that you can make. However, naming only your spouse or your child as a beneficiary may not always be enough. What if your spouse or named beneficiary passes away before you? Or what if you and your spouse die together in a tragic event like a car accident?
Depending on your beneficiary designation, the insurance company may pay your estate the death proceeds if you haven’t named or beneficiary or they’re no longer alive when you die. Suffice to say, this could lead to other problems for your estate to untangle.
2. Failing to list contingent beneficiaries.
You should designate a primary beneficiary and a contingent beneficiary in your life insurance policy, advises the III. If your primary beneficiary is found after your death, they receive the death benefits. If the primary beneficiary cannot be found, the death benefits are paid to contingent beneficiaries. The death benefit will be paid to your estate if the primary or contingent beneficiary can not be found.
“If you’re married, your spouse is normally your primary beneficiary and your child or children are contingent,” explains Ken Nuss for Kiplinger. “The contingent beneficiaries will receive the proceeds on your death if your primary beneficiary dies before you do or at the same time as you do.”
“While you should notify the insurer about the death of a primary beneficiary, even if you don’t, the proceeds will automatically go to your contingent beneficiaries,” adds Nuss.
3. Not understanding the difference between revocable and irrevocable designations.
Revocable beneficiaries are common in life insurance policies. The owner of the life insurance policy remains in control of this type of life insurance designation, clarifies Fidelity Life.
If you own a policy, you can change the revocable beneficiaries or change the percentage of the payout that each beneficiary receives. Changing your beneficiary is usually as simple as filling out a form, and your beneficiaries don’t have any say in the matter. This approach allows you the flexibility to change beneficiaries as your situation and priorities change during the policy.
It can be a little bit more complicated to handle life insurance policies with irrevocable beneficiaries. Unless the irrevocable beneficiary approves, you’re not allowed to change beneficiaries. If you wish to modify beneficiaries, both the current beneficiary and any contingent beneficiaries must consent.
In short, irrevocable beneficiaries are basically guaranteed to receive life insurance proceeds, unless they agree to be removed from the policy. You should be 100% sure about your irrevocable beneficiaries if you add them to your life insurance policy. As such, its children often are named as irrevocable beneficiaries in life insurance policies.
4. Lack of specifics.
If you are part of a blended family, just listing “my children” as your beneficiaries could be problematic. In fact, the term “children” is not recognized in most states when referring to stepchildren. There’s also the possibility that a distant family member may pop up and attempt to take some, maybe even all of, your estate even though that’s not what you had intended
Last but not least, what happens if one of your children dies? Unless you provide detailed instructions, the child’s share will go to your other children and not that child’s heirs. In order to avoid disinheriting some of your children or grandchildren, unless that’s your plan, you need to be as specific as possible.
5. Naming a minor child as your beneficiary.
When a parent or both of them passes away unexpectedly, life insurance will provide for their children. At the same time, it may not always be a good idea to name minors as beneficiaries.
Minors cannot receive life insurance benefits directly from life insurance companies. The court can appoint a guardian to manage your minor children’s life insurance proceeds if you buy it without creating a trust or making any other legal arrangements. In this case, it’s better to set up a trust and name the trust as the beneficiary of the policy. It’s also possible to designate an adult custodian for the proceeds of the policy under the Uniform Transfers to Minors Act.
6. Naming a beneficiary who has special needs.
An additional issue appears when direct beneficiaries are referred to as individuals with special needs. For instance, special needs individuals may receive government benefits based on their income, like Supplemental Security Income, Medicaid, or housing assistance. As such, they may be disqualified from receiving government assistance if they are named as a direct beneficiary since this would increase their income.
“Fortunately, you can still get life insurance on your life,” states Rubin Law. “Establish a third-party special needs trust (SNT) that benefits your child, and name the SNT as the policy beneficiary.”
In the event of your death, the lump sum will be paid to the trust. For government benefits purposes, money held by SNTs is not usually counted as income. In fact, the SNT may be able to pay some expenses directly without affecting eligibility for benefits.
7. Not updating your policy.
“It’s more common than you might think to find someone listed as the beneficiary of a former spouse’s life insurance policy,” writes Mary Randolph, J.D. for Nolo. “And after the policyholder dies, there’s nothing anyone can do about it.”
“Update your beneficiary designations (pensions, retirement accounts, and payable-on-death bank accounts as well as insurance policies) whenever there’s a big life event: you get married, divorced, or a child or grandchild joins the family,” advises Randolph.
8. Death benefits will go to your estate.
There are several problems when your life insurance proceeds are paid to your estate. First, the proceeds may be subject to probate, which could delay your heirs’ payment of the policy proceeds. Second, since your life insurance is part of your probate estate, your creditors are entitled to claim the proceeds.
Furthermore, your creditors may be able to satisfy their claims out of those proceeds before your heirs are able to receive their share. Having your primary, secondary, and final beneficiaries named can prevent the proceeds from being distributed to your estate.
9. Not understanding the difference between per stirpes or per capita?
Many people name more than one beneficiary to receive the proceeds of life insurance. But, this can get hairy if one of the beneficiaries dies before you.
Would you like the share of the deceased beneficiary to be included in the share of the surviving beneficiaries? Or should it be passed on to their children? Per capita vs. per stirpes is the distinction.
While it’s not necessary to use legal terms on the insurance beneficiary designation form to indicate what happens if a beneficiary dies before you do. It is, however, important to indicate how you wish the share to pass if a beneficiary dies before you do.
Per stirpes (by branch) means the next generation inherits the share of a deceased beneficiary. Per capita (per head), means that each surviving beneficiary receives an equal share of what the deceased beneficiary would have received.
10. Being taxed by having a different policy owner, named insured, or beneficiary.
In general, life insurance death benefits are tax-free. The death benefit may be taxable if you have a life insurance policy that is owned by one person, insured by another, and benefitted by a third.
By naming your adult child as the beneficiary of the life insurance policy on your spouse, you effectively give your child the benefits of the policy. It is possible in this situation that you are subject to federal taxation if the total amount exceeds the limits. A financial advisor can assist you in structuring your life insurance policy in order to possibly avoid a tax situation in such circumstances.