I’ve reviewed over two dozen life insurance policies this year. Aside from the big problems I currently see in cash value policies, the beneficiary designation is important because a mistake can be costly. Perhaps because so much thought, energy, time, and money is spent deciding upon the type of policy and coverage, the simple detail of beneficiary gets overlooked.
Estate as Beneficiary
If your policy has your estate as the beneficiary, and your will then directs who will receive your assets from your estate, the life insurance proceeds are now subject to federal and state estate taxes. Currently, the first $5.25 million of estate assets are exempted from federal taxes, so if you die tomorrow with less than that in your name, you may not have to worry about paying a chunk of your death proceeds to the IRS rather than your heirs.
In reality, we don’t know what the exemption will be when you pass away, and you don’t know what you may be worth when that happens. Having your estate as beneficiary means including the face amount in your total also means potential estate tax at the state level since state thresholds can start at $675,000, with most starting at $1 million.
Spouse as Beneficiary
While it’s more tax-efficient to put your spouse’s name on the beneficiary form, people often forget to name secondary beneficiaries. Another costly mistake because if you and your spouse die at the same time with no secondary beneficiaries listed, then the proceeds go right back into your estate. Even if you predecease, if your spouse dies without naming a proper beneficiary, what’s left of your life insurance payment could be subject to estate taxes.
Children as Beneficiaries
This can avoid the estate tax but you have to give up ownership of the policy. (Ownership transfer must have occurred more than three years prior to death to be excluded.) Probably not the best option if your spouse needs those assets for income. I reviewed one policy where the son was the beneficiary with the understanding that he would divide the money with his siblings. Wrong! If he receives the life insurance proceeds, it arrives tax-free. But when he pays the money to his other brother and sister, those become taxable gifts.
You have some basic ways to prevent life insurance proceeds from being included in your estate. The easiest and most practical solution is never to own it in the first place. The beneficiary should purchase and own the policy. Consider an irrevocable life insurance trust. You will assign the ownership of the policy to the trust, and gift the amount of the insurance premiums to the beneficiaries of that trust, with the provision that they use that money to buy the policy and keep it current. While you will give up control over the policy and premiums, this trusted technique will ensure that your policy avoids estate tax. In addition, you can design the trust to support your spouse, and determine how, when, and who gets the ultimate proceeds after his/ her lifetime.
At the very least, double-check your policy’s beneficiary designation and make adjustments if necessary.