Who Gets Your Life Insurance Payout?

Life insurance is a crucial aspect of financial planning, allowing individuals to provide for their loved ones after their death. While the policyholder typically designates themselves or a family member as the beneficiary, it is possible to direct life insurance proceeds to someone else. This scenario commonly arises when an individual wishes to insure a business partner, key employee, or even a former spouse. Obtaining consent from the insured and establishing insurable interest are essential prerequisites for buying life insurance on someone else. Additionally, the insured person must participate in the application process and undergo the underwriting process, which may include a medical exam. It is worth noting that the policy owner retains control over the policy and can update beneficiaries or change coverage amounts. By understanding the legal and ethical considerations, individuals can effectively utilize life insurance to protect their interests and provide financial security for their beneficiaries.

Life insurance and tax

Life insurance proceeds are generally not taxable. When the policyholder of a life insurance policy passes away, the proceeds, or death benefits, are paid to the named beneficiary or beneficiaries. This payout is typically not considered part of the beneficiary's gross income and is therefore not subject to income or estate taxes.

However, there are certain situations in which life insurance proceeds may be taxed. Here are some key scenarios to consider:

• Payout structure: While a lump-sum payout to the beneficiary is usually tax-free, if the payout is structured as multiple payments, these may be subject to taxes. This includes annuities, which are paid regularly over the life of the beneficiary and can be taxed as income.
• Withdrawal or loan against the policy: Some life insurance policies, such as whole life insurance, accumulate cash value over time, allowing the policyholder to withdraw funds or take out a loan. If the amount withdrawn or loaned exceeds the total premiums paid, the excess amount may be taxable.
• Surrendering the policy: If you surrender a life insurance policy, the amount you receive is typically considered a tax-free return of your principal. However, any amount exceeding the policy's cash basis will be taxed as regular income.
• Employer-paid group life plan: In certain cases, an employer-paid life insurance plan that pays out more than a specified threshold (e.g., $50,000) may be taxable, according to the Internal Revenue Service (IRS).
• Estate tax considerations: Life insurance proceeds are considered part of the deceased's estate for tax purposes. If the total value of the estate, including the life insurance proceeds, exceeds the federal estate tax exemption ($13.61 million in 2024 or $12.92 million in 2023), estate taxes may be due. Proper estate planning, such as setting up a trust, can help minimize these taxes.
• Interest received: Any interest received on life insurance proceeds is generally taxable and should be reported as interest income.

It is important to note that tax laws and regulations can vary by jurisdiction, and specific advice should be sought from a qualified tax professional or financial advisor regarding your particular situation.

Policy ownership

It is essential to understand that the insured person's role is distinct from the policy owner's role. The insured individual undergoes the underwriting process and has the option to consent to the policy. In most cases, the insured person must be aware of and agree to the policy, except when it involves a child. The insured person's consent is crucial, and they may also need to provide personal information and undergo a medical examination.

In certain situations, it is permissible to buy life insurance for another person. This typically requires demonstrating an "insurable interest," which means proving that you would suffer financial loss or hardship if the insured person died. Common scenarios include insuring a spouse, business partner, key employee, child, or even a former spouse or parents. The policy owner can be the beneficiary of the policy, but it is not a requirement, and multiple beneficiaries can be designated.

Transferring ownership of a life insurance policy is possible but complex. It usually occurs due to estate tax planning or changes in financial or life circumstances. There are three primary methods for transferring ownership: absolute assignment, collateral assignment, and irrevocable life insurance trust (ILIT). Absolute assignment involves irrevocably transferring all rights and ownership to another person or entity, giving them complete control over the policy. Collateral assignment is a temporary method where the policy is used as security to obtain a loan, with ownership reverting to the original owner once the loan is repaid. An ILIT is a trust that owns the life insurance policy, often used to reduce or avoid estate taxes by providing liquidity to the estate.

Primary and contingent beneficiaries

When setting up a life insurance policy, it is essential to designate both primary and contingent beneficiaries to ensure your assets are distributed according to your wishes.

Primary Beneficiaries

A primary beneficiary is the first person or entity in line to receive the assets or benefits from your life insurance policy, retirement account, or estate upon your death. This individual or group has the primary claim to the inheritance and receives the proceeds directly, bypassing the need for probate, provided all conditions are met. You can name more than one primary beneficiary and specify how the assets should be divided. The primary beneficiary designation can be changed at any time, provided you are of sound mind and not under duress.

Contingent Beneficiaries

A contingent beneficiary, also known as a secondary beneficiary, is the person or entity that stands to inherit the assets if the primary beneficiary is unable or unwilling to do so. They are essentially a backup to the primary beneficiaries and only receive the assets if the primary beneficiary is deceased or otherwise unable to claim the inheritance. You can designate multiple levels of contingent beneficiaries to ensure a clear line of succession.

Why Both Designations Are Important

Naming both primary and contingent beneficiaries is crucial for comprehensive estate planning:

• Avoid Probate: Properly designated beneficiaries can help avoid the lengthy and costly probate process.
• Ensure Wishes Are Fulfilled: Contingent beneficiaries ensure that your assets are distributed according to your wishes, even if the primary beneficiaries cannot receive them.
• Clarity and Security: Clear designations prevent disputes among potential heirs and provide peace of mind, knowing that your loved ones are taken care of.

How to Designate Beneficiaries

When setting up your beneficiaries, follow these steps:

• Identify Beneficiaries: Determine who you want to designate as your primary and contingent beneficiaries.
• Specify Details: Clearly state the names, relationships, and percentages or specific amounts each beneficiary should receive.
• Review Regularly: Life changes, such as marriages, births, deaths, or divorces, may require updates to your beneficiary designations.
• Consult Documentation: Ensure your designations align with the specific rules of the financial institution or policy.

Transferring ownership

There are usually multiple people involved in a life insurance policy, and each person has certain responsibilities and rights. The policy owner is the person who controls a life insurance policy during the insured person’s lifetime. They can be the insured person or someone who purchased life insurance for someone else, such as a child or partner. The insured person is the individual whose life is covered under the insurance policy. If they die, the life insurance benefits pass directly to the beneficiaries named in the policy.

There are three methods to transfer a policy's ownership:

• Absolute assignment: This involves transferring all rights and ownership of a life insurance policy from yourself to someone else or a legal entity. This is an irrevocable decision.
• Collateral assignment: This allows you to use a life insurance policy you own to obtain a loan. This is a temporary arrangement.
• Irrevocable life insurance trust (ILIT): This is a type of trust that owns a life insurance policy as its primary asset. This is used to reduce or avoid estate taxes.

To transfer a life insurance policy to someone else, you need to sign a simple document, called an "assignment" or a "transfer". It is recommended that you consult an attorney to understand the implications and your options, and to help with the transfer process. You will also need to notify the insurance company and use their form to make the transfer. There is normally no charge for this.

If you transfer ownership of your policy to another person, you lose all power over it. You cannot cancel the transfer or change the beneficiary. You should also be aware of the IRS rules on life insurance transfers, which include rules on gifts of life insurance policies made within three years of death, and "incidents of ownership", where the deceased has kept some power over the transferred policy.

Ethical considerations

When considering taking out a life insurance policy on someone else, ethical considerations play a crucial role. Here are some key points to keep in mind:

Insurable Interest

It is essential to have a genuine financial interest in the person you plan to insure. Without this, it could lead to moral hazards and conflicts of interest. You must be able to demonstrate that you would suffer a financial loss if the insured person passes away. This could include loss of income, increased financial responsibilities, or shared debts.

Informed Consent

Respect the autonomy and privacy of the individual by obtaining their informed consent before proceeding with any insurance arrangement. Communication and transparency are vital in navigating ethical complexities. Ensure the insured person understands the implications of the policy and has given their consent in writing.

Relationships and Trust

Consider the potential impact on relationships and trust. Taking out a policy without the insured's knowledge or against their wishes can strain or damage relationships irreparably. Open and honest communication is key. Ensure all parties involved are aware of the policy and its implications.

Values Alignment

Ensure the insurance arrangement aligns with your values and ethical principles. Taking out insurance solely for financial gain without considering the well-being of the insured raises significant ethical concerns. Reflect on your motivations and ensure they are in line with your values.

Empathy and Responsibility

Approach the decision with empathy, integrity, and a deep sense of ethical responsibility. Consider the broader implications of the insurance arrangement beyond financial gain. Think about how the policy could impact the insured person's future planning and financial stability.

Ethical Sales Practices

If you are selling or advising on long-term care insurance, you must disclose all relevant information to your clients. This includes informing them of any disadvantages, costs, and your own interests in the transaction. Maintain confidentiality and comply with all state and federal privacy regulations.

Frequently asked questions