I admit that the topic of selecting the right insurance beneficiaries isn’t exactly riveting. OK…it’s actually a super snooze topic. You got me. But that’s the root of the problem.
Most people don’t give this the attention it deserves and their family ends up paying the price. People typically jot down the name of their spouse or children or trust for their insurance beneficiary without giving it much thought and it can end up costing hundreds of thousands of dollars. I implore you not to approach this topic so casually.
What good is buying life insurance only to see it go down the IRS drain? And don’t expect your financial team to always have the right answers here. Even if you ask your financial advisor you could get the wrong advice. And your lawyer might blow it too. I’m amazed by this of course but also appalled at how frequently paid professionals slip up when it comes to the designation of the proper life insurance beneficiary.
The Basic Problem
The basic problem is that there is no “one size fits all” when it comes to life insurance beneficiary designations. There are drawbacks to any decision you make. But make no mistake. There are some designations which are slightly flawed while others are downright catastrophic. Let’s try to go through some of the choices now and understand how important this decision really is.
Please keep in mind that I am not attorney and what follows is not legal advice. If anything, the following post is meant to help you ask smart questions and get better professional advice. There is no substitute to having qualified professional council when it comes to choosing the right insurance beneficiaries.
In most cases, the worst possible choice is to name your estate as the beneficiary of your life insurance. That’s because this election might expose the insurance benefit to both estate tax and to probate. Double whammy. “Thank you sir…may I have another?” And what kills me is that this is completely avoidable.
Anytime you or your estate have what the IRS calls an “incident of ownership” of the life insurance, that insurance becomes part of your taxable estate and subject to estate tax.
Right now, you only have to worry about paying estate taxes if your taxable estate is worth more than $5.25 million. But who knows what the estate tax code will be when you do finally punch your ticket? And who knows how much you’ll be worth at that time? Your estate could easily find itself invited to dinner with the IRS – as the main course. And this is to say nothing of the probate migraine you create for yourself if you name your estate as the beneficiary of your life insurance. Why subject your life insurance to this hell when it’s so easy to avoid?
Probate is the “drecky” process by which lawyers and courts get together and play ping pong with everything you’ve worked hard to accumulate. When you name your estate as the beneficiary of anything, the state has to determine what that means. They apply local law and the lawyers get to argue every which way possible in order to eat up lots of time and money. It’s a horrible process that only the truly masochistic would wish on their heirs. Friends don’t let friends name their estate as the beneficiary of their life insurance. Just say “no”.
Naming your spouse might be a good option – it’s certainly far better than naming your estate because it avoids probate and estate taxes (temporarily). But if you and your spouse die at the same time or if he dies before you (and you don’t have a secondary beneficiary), the money is going to be paid out to your estate. I’ve already told you how incredibly stinky that is.
Even if your spouse survives you, you have no control over what he might do with the money once you are out of the picture. He might remarry and name his new squeeze the beneficiary of the estate. That would leave your kids out in the cold. I’ve seen this happen more than once. And even if he doesn’t do something dumb like that, there is still the problem of estate taxes and probate. If he dies without naming a proper beneficiary, what’s left of the life insurance proceeds could easily end up in probate and subject to estate taxes too. That’s a crying shame that has to be avoided at all costs.
Your Children or Siblings
Naming your children or siblings might work as an alternative. It certainly gets rid of the probate problem and it could help you sidestep the estate tax concern if you also give up ownership of the policy. But there are still some problems with this. Of course if they don’t do proper planning, their assets might be subject to estate taxes and probate. But that’s for them to worry about.
A bigger issue for you is divorce and liability. If you leave a ton of money to a loved one and then that person gets divorced or sued, your money might be stripped away from them.
And there are other problems with this decision. Often people name one sister or one child as beneficiary. The intent is for that one sibling or child to divvy up the money among the other family members. This presents all kinds of problems. Besides creating all kinds of rivalry between the family, it creates a tax burden as well because this is a taxable gift. If your child (for example) gives more than $14,000 to any one person in any one year, it becomes a taxable gift. Of course there are ways to minimize the pain associated with gift taxes but this route creates problems.
A Living Trust
If you name your living trust as the beneficiary of your life insurance it solves the probate issue but not the estate tax issue. That’s because if you are the owner of the trust (and most trusts are set up this way) you technically have an incident of ownership and that means the life insurance is included in your estate. Again, you may not have a problem with this if your taxable estate is less than the estate tax threshold but it is something to be aware of.
There are many benefits of the trust however. First, it gives you a great deal of control and it’s very simple to administer. For many people, this could be the way to go.
Have you been procrastinating setting up a living trust? Consider using a service like Legal Zoom.com. They aren’t attorneys but they do provide a great service for the right people at an extremely competitive price.
An Irrevocable Life Insurance Trust
If you really want to protect your life insurance from estate taxes and probate, consider setting up an irrevocable life insurance trust. This path gets you out of the estate tax and probate train wreck. But in order to make this work you must:
- Irrevocably assign the ownership of the life insurance to the trust
- Gift the premiums for the insurance to the beneficiaries of the irrevocable life insurance trust (and hope they use that money to pay the insurance premiums).
If you go this route you can’t be the owner or the trustee of the trust and you can’t have any control over the policy or the premiums. If you are fine with these limitations and want to make sure your life insurance won’t be included in your taxable estate this is the way to go.
You have to select your life insurance beneficiaries carefully. Besides probate, you have to consider estate taxes. And even though these taxes only kick once your taxable estate exceeds $5.25 million today, that threshold could change. Also, when you include your home, your savings, investments, retirement accounts and other assets, you might find yourself in the cross hairs of the IRS pretty easily. There are solutions to these problems but there are no perfect solutions. Once you understand the pros and cons of the various options, my suggestion is to go speak with a qualified attorney and work out a plan that is right for you and your family.
Who is your life insurance beneficiary now? Is it the right choice? Are you going to make any changes? Why?