How to Avoid the 8 Most Common Life Insurance Mistakes

To avoid federal and state estate inclusion of life insurance proceeds, a life insurance policy owner may want to have a trust or an adult beneficiary purchase, own and be the recipient of the life insurance policy on the insured’s life. If an individual does not own the life insurance policy or has any rights to it, then under present tax law, it cannot be included in the individual’s estate. This is true even if the individual gifts an adult child or trustee cash gifts that are used to pay the premiums.

Mistake #6. The death proceeds of an individual’s life insurance policy are payable outright to the individual’s minor children or grandchildren.

Improper bequeathing of assets is one of the most frequent and serious of all estate planning errors. It occurs when the wrong asset is bequeathed to the wrong person at the wrong time. When it comes to bequeathing assets, “equal” is not necessarily “equitable,” especially when it comes to children. It is quite possible that each child has different needs. Some questions for parents who own life insurance policies to consider: (1) Should each child receive equal shares of a parent’s life insurance death proceeds? (2) Should each child receive their share outright? (3) Is a child sophisticated enough to invest his or her inherited share wisely? and (4) Are children mature enough to handle such a large amount of money? Note that in many cases, state law will tie up death proceeds paid to a minor child and make it more expensive or time consuming for minor beneficiaries to use the money. No insurance company will knowingly pay large amounts of money to minor children. That means a guardian or custodian will have to be appointed by a court to pay out the children’s inherited share. Perhaps the best solution is for the policyowner to set up a trust for the policyowner’s spouse and children and name the trust as the recipient of the life insurance proceeds. This is a safer and surer way to provide financial independence for those beneficiaries who cannot or do not want to handle large sums of money or assets.

Mistake #7. A life insurance policyowner names his or her estate as beneficiary.

Naming one’s estate as beneficiary of a life insurance policy dooms the proceeds in many states to unnecessary state inheritance taxes, or to a higher inheritance tax rate than if the death proceeds were payable to a named beneficiary. This mistake also makes possible that creditors have full access to the life insurance death proceeds. This is the case even though most states laws provide full or significant exemption from the claims of creditors for life insurance death proceeds, payable to named beneficiaries such as a spouse, adult children, siblings or parents. Moreover, by naming the policyowner’s estate as beneficiary, the policyowner will guarantee that the death proceeds the policyowner wanted to give to a loved one will be subject to the delay and expense of probate.

Mistake #8. Failing to name contingent beneficiaries.

If the beneficiary a life insurance policyowner named dies before the policyowner, and a new beneficiary subsequently is not named, then at the policyowner’s death, the death proceeds will be paid to the policyowner’s estate. This needlessly subjects it to all the problems of Mistake #7, just as if the policyowner had outright named his or her estate as beneficiary.

The solution is that the policyowner is advised to name two “contingent” beneficiaries for each primary  beneficiary named in the life insurance policy. The idea behind naming a “contingent” beneficiary is that upon the death of a named primary beneficiary, a named contingent beneficiary automatically becomes the primary beneficiary. A policyowner could name as many primary beneficiaries as needed, with each primary beneficiary named has two named contingent beneficiaries.

The “Rule of Two” in which two “backups” are named as beneficiary, is a good practice for all of an individual’s dispositive documents, and contracts. For example, naming contingent beneficiaries in one’s will, trust, for the TSP, for traditional IRAs and Roth IRAs, for bank accounts (via payable on death designation) and for brokerage accounts (via transfer on death designation) is a recommended estate planning practice.

These policies have exclusions and/or limitations. The cost and availability of life insurance depend on factors such as age, health and the type and amount of insurance purchased. As with most financial decisions, there are expenses associated with the purchase of life insurance. Policies commonly have mortality and expense charges. In addition, if a policy is surrendered prematurely, there may be surrender charges and income tax implications. Guarantees are based on the claims paying ability of the insurance company.

Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street - Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.