10 ways to screw up when picking life insurance beneficiaries

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."

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.

Here's more on life insurance planning for parents of children with special needs.

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:
  • Arizona
  • California
  • Idaho
  • Louisiana
  • Nevada
  • New Mexico
  • Texas
  • Washington
  • Wisconsin.

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 your 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?

6. Forgetting to update

"Designating beneficiaries are not 'set it and forget it' events," says Tara Reynolds, vice president at MassMutual. You should review your policy every three years and after major life events, such as marriage, having children or divorce. Change the beneficiaries when circumstances change.

Unfortunately, many people forget to do so.

"Half of my practice is second or third marriages," says Peter Blatt, a tax attorney and financial adviser in Palm Beach Gardens, Fla. "It's not uncommon to find the ex-spouse still listed as beneficiary on the life insurance policy" when reviewing a client's portfolio.

7. Neglecting details

Be specific when you name beneficiaries. Instead of "my children," list their names, Social Security numbers and addresses, says Ed Graves, a professor of insurance at The American College in Bryn Mawr, Pa.

Otherwise, "the insurance company has to launch a search and that can take a lot of time," Graves says.

When naming multiple beneficiaries, decide whether you want the money divided "per stirpes," which means by branch of the family, or per capita, which means by head. (See sidebar.)

8. Staying mum

"The most important thing is to tell someone so they know you have a life insurance policy, where it is and how to find it," says Joshua Hazelwood, vice president at MassMutual.

Open communication with beneficiaries now can save a family from chaos later - or even worse, never claiming the benefit.

If your relative didn't give you enough life insurance policy information, here are tips for finding lost policies.

9. Giving money with no strings attached

Naming your young-adult children as beneficiaries without setting any conditions for how the money is dispersed can be a setup for financial failure. How many 18- or 21-year-olds can handle a huge influx of cash? One way is to set up a trust with specifics for how the money can be released and what it can be used for until the young adult reaches a certain age.

"It allows me as a parent to instill what I feel is valued in my absence," Friedman says. "I don't want to leave my children with millions of dollars when they're 18 with unfettered access."

Insurers are beginning to introduce policies that let you arrange for the death benefit to be paid out in installments. Minnesota Life Insurance Co.'s new indexed universal life product, Omega Builder IUL, includes that option, calling it an "income protection agreement."

10. Naming only a primary beneficiary

"Most people just think they're going to make their spouse beneficiary, but don't take into account the spouse might predecease them," Friedman says. "It's conceivable that something would happen to you and your spouse together."

Blatt says he even sees cases where people fail to name any beneficiaries. When there is no living beneficiary, the life insurance benefit typically goes into the estate and is subject to probate. That leads to two complications. One, heirs might face a long wait to get the money. Two, the life insurance proceeds, which normally would be protected from creditors, now can be used to pay off creditors.

Advisers recommend naming secondary and final beneficiaries. If the primary beneficiary dies before you do, then the money passes to the secondary beneficiary. If the secondary beneficiary has passed away when you die, then the death benefit goes to the final beneficiary.

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