Choosing a beneficiary for your life insurance policy is one of the most important parts of the application and purchasing process. After all, the reason for purchasing a policy is to financially protect your loved ones. In order to do so, you’ll need to ensure the payout for the life insurance policy (called a death benefit) is properly delivered to them in the event of your death.
While choosing a beneficiary may seem pretty straightforward, errors are often made that cause significant issues and incur unnecessary expenses. Even worse, it can put additional stress on your loved ones during an already difficult time.
Because our purpose is to get you prepared for whatever life may throw at you, here’s how to help ensure there aren’t any missteps when you’re naming a beneficiary for your life insurance policy:
What is a beneficiary?
Let’s start with the basics. A beneficiary is the person you name who will receive the payout for the death benefit specified in your life insurance policy. You may name more than one beneficiary. If you choose to do so, you’ll need to designate the amount or percentage that goes to each person.
Who should you name as a beneficiary?
Most people name their spouse, partner, child, parent and/or anyone who relies on them financially as a beneficiary. In some cases, people name an entity (like a trust fund) as a beneficiary.
It’s a good idea to name both a primary and alternate (sometimes referred to as contingent) beneficiary. For example, if you name your spouse as a primary beneficiary and both of you were to die at the same time, who would you want to receive the death benefit? If it’s your sibling, you’d need to name him or her as the alternate beneficiary to ensure the appropriate person receives the payout.
Be prepared to submit the following when naming your beneficiary(ies) – the more specific you are, the better:
- Full name
- Date of birth
- Social Security Number
- Amount or percentage they should receive
If you are setting up a trust fund to name as beneficiary, make sure to consult an attorney or financial advisor familiar with this transaction for additional details.
Common mistakes to avoid
Not telling someone they are the beneficiary – While this might seem like a surprising scenario, it’s pretty common. No one likes to talk about or even think about death. Make sure your beneficiary knows you purchased a policy, how much it’s for and where they can find the details of the contract in the event of your death.
Naming a minor as beneficiary – Legally a child under 18, and in some states 21, can’t access a life insurance death benefit. If you haven’t named a legal guardian or set up a trust to manage the money, the court will handle distributing the death benefit for you, which can get very complicated. There are a few ways to navigate this tricky situation. The easiest solution is to set up a UTMA custodianship with the life insurance company. This ensures that the child receives the full death benefit for the policy. You’ll also need to name a custodian who will be responsible for the assets until your child is no longer deemed a minor by the state (typically between ages 18 and 21). Another option is to set up a trust fund that the policy can be paid to. If you decide to go the trust route, make sure it specifies how the money should be paid out – installments, a lump sum when the child turns a specific age, etc.
Forgetting to update your beneficiaries – Just like you should review your policy needs after major life events, you should also revisit your policy beneficiaries and the listed information periodically. Common errors include: incorrect contact information, listing a former spouse, or listing a legal guardian when a child is no longer a minor.
Not considering government assistance – If your beneficiary receives government assistance of any kind, you’ll want to ensure that receiving a death benefit from your life insurance policy won’t disqualify them from further assistance. For example, if you have a special needs child and name him or her as your beneficiary, they may no longer be eligible for government assistance because of the sum of the “gift.” This is another instance where you’d want to look into naming their legal guardian as the beneficiary or establishing a special needs trust fund.
Assuming a will covers all updates – Your life insurance policy is a legal contract, which means the terms listed on it are the ones that go into effect if you die. Your will does not control or trump this contract. For example, if your will lists the beneficiary as your husband and the life insurance policy has your ex-husband listed as the beneficiary, the death benefit will be paid to your ex. Best to avoid that potentially uncomfortable situation altogether by consistently monitoring your beneficiary designations.
Making your death benefit taxable – Here is where things get pretty tricky. Typically, a life insurance death benefit is received free from federal income tax. However, there are situations where the payout can be deemed either an income taxable event or a “gift” that could be subject to federal and state gift taxes. Let’s start with the income tax event, if you or your business own a policy and name your employee the beneficiary this is considered compensation and subject to income taxes.
Also, your death benefit could become taxable as a gift if you own the policy on your spouse and then name your child as a beneficiary. This is known as a “Goodman Triangle” or The Goodman Rule. This rule is derived from a 1946 Tax Court case that states if a third-party beneficiary is involved (someone who isn’t the owner or the insured) then the death benefit is deemed a gift and may be subject to gift tax. To avoid this, the insured and the owner should be the same person.
The purpose of purchasing a life insurance policy is to provide financial security for your loved ones, and a key part of the policy benefit is making sure it’s easily distributed to your beneficiary. It’s important to not treat naming a beneficiary like a checkbox in your life insurance application process. Be thoughtful about who you are naming as beneficiary, the information you provide on them and periodically check in to ensure accuracy. This due diligence early on and throughout the life of your policy will save your loved ones unnecessary stress, aggravation and potentially a lot of money if you die.