Talking about life insurance is a subject most parents avoid, and for good reason. No one wants to think about something happening to them and affecting their kids. But making these tough decisions early on can be one of the best things that you do for your family — to give you peace of mind by preparing for the worst.
Life insurance is, in most cases, intended to ensure that your family has the resources it needs to survive if something were to happen to you and/or your spouse. It’s not pleasant to think about but realistically, most of us don’t have a nest egg sufficiently large enough to provide ongoing financial support for our families if we were to pass away.
Life insurance can, for a modest investment, help families pay off bills and keep going after a parent dies. Buying a policy isn’t terribly complicated (in most cases). But figuring out your beneficiaries can be.
Here’s a quick rundown of common beneficiary designations that might not be so desirable:
1. Naming your minor child as the beneficiary
This tends to be the default on insurance policies because it feels simple but the result is anything but. Minors cannot, by law, control their own property — and that includes money. If your minor children are the direct beneficiary of a life insurance policy, it will be necessary, in most instances, to name a guardian to manage the proceeds even if the child’s other parent is still alive. This can be time-consuming and costly.
2. Naming your just-barely-not-a minor child as the beneficiary
Assuming that your child is no longer a minor, there are no legal impediments to naming your child as a beneficiary but there are some practical ones. Chief among them: Young adults may not be prepared for the responsibility of taking care of a lump sum of money. Even worse? There might be other folks in the child’s life who might not have their best interest at heart whispering in their ears.
3. Naming an adult as the beneficiary with direction to “take care” of your children
It might be tempting to name an adult as the beneficiary and have a side agreement for the adult to take care of the child with the life insurance proceeds. There are real dangers, however, with this kind of arrangement since the adult is under no legal obligation to use the proceeds for the benefit of the child.
So what does tend to work?
There’s no one-size-fits-all answer. It’s important to communicate your specific needs to your financial planner and/or estate and tax attorney in order to find the best fit.
When minor children are involved, a trust is often a good idea. A trust can easily be named as the beneficiary of life insurance proceeds. You can structure the terms of the trust to provide for your children in the manner and timeframe that you think best. Trusts, when drawn properly, can be used to offer creditor protection, asset management options and in some instances, a trust can also be used to move funds out of your estate for federal estate tax purposes.
While life insurance is not taxable to a beneficiary as income, that’s not to say that there won’t be any tax consequences. Any interest, dividends or other income attached to the death benefit will retain their character, for tax purposes, in the hands of a beneficiary — and that includes a trust. You’ll want to check with your tax advisor for the best advice on how to structure your trust for income tax purposes.
Don’t forget your spouse!
Of course, it’s important not to forget about your spouse. If your plan is to leave enough insurance to provide for your spouse during his or her lifetime, don’t skip the spouse altogether and leave the proceeds solely for the benefit of the children. If you want to include the spouse, consider naming him or her as the beneficiary (but see again #3 above) or create a “sprinkle” trust that allows for the benefit of your spouse and children.
Don’t get too carried away on the estate planning document side: Your will does not control your life insurance policy. To ensure that your wishes are carried out, work with your attorney and your life insurance agent directly to complete and submit change of beneficiary forms. Simply referencing your beneficiary inside of your will or trust will not direct the proceeds where you want without a specific beneficiary designation on the life insurance policy.
Finally, be sure and follow up. The funny thing about kids is that they won’t stay little forever. They grow up and become — we hope — responsible adults. As their needs change, your plans should change. Be sure to check in regularly with your financial advisors, including your attorney and your insurance agent, to make sure that your plan makes the most sense for your family.
Updated by Bethany Ramos on 2/5/2016