Life Insurance Money: Strategies For Effective Distribution

Life insurance is a financial safety net for your loved ones after you pass away. It's a contract between a policyholder and an insurance company that pays out a death benefit to the beneficiaries. When purchasing a life insurance policy, it's crucial to understand how the process works, including choosing beneficiaries and the different ways they can receive the proceeds.

Beneficiaries can be individuals or organisations with an insurable interest in your life, meaning they would suffer a financial or other type of loss if you were to die. They can include your spouse, children, a charitable organisation, or a legal entity like your company.

When choosing beneficiaries, you can select a primary beneficiary who is first in line to receive the benefit, and a contingent beneficiary who will receive it if the primary beneficiary dies before you do. You can also specify the percentage of the payout each beneficiary will receive, ensuring it adds up to 100% in total.

There are different methods for distributing the proceeds among multiple beneficiaries, such as per stirpes (by branch of the family) or per capita (by head). Working with a qualified insurance professional or estate planning attorney can help ensure your wishes are met.

Additionally, there are various payout options available, including lump-sum payments, installment payments, annuities, and retained asset accounts. Each option has its advantages and disadvantages, and it's important to carefully consider which one best suits your beneficiaries' needs.

Remember, choosing and updating your life insurance beneficiaries is an important but sometimes tricky task. It's essential to review and adjust your policy regularly, especially after significant life events, to ensure your wishes are up to date and your beneficiaries are protected.

Naming a minor child as beneficiary

When applying for life insurance, you will be asked to name a beneficiary for your policy. While this is usually pretty straightforward, it's important to be aware of some potential complications if you're considering naming a minor child as a beneficiary.

Life insurance companies will not release a policy payout to a child who has not reached the "age of majority" (usually 18, but this depends on the state). If a minor becomes the beneficiary of a life insurance payout, the probate court will appoint a guardian for the minor's estate, and this guardian will retain oversight over the estate and its money until the child reaches the legal age of majority. This process can be costly and time-consuming, preventing the money from being used to support your family in the ways you intended.

There are a few ways to overcome this obstacle:

• Assign a custodian for the child. A custodian will act as the guardian of the money and assets intended for the minor child, making way for valid transfers under the Uniform Transfers to Minors Act. A properly designated custodian may make decisions concerning those assets as long as they are in the best interests of the minor child. Once the child becomes a legal adult, the assets are turned over, and the custodian's role ends.
• Name a living trust as the beneficiary instead of the child. A revocable trust is a popular estate planning tool that allows you to indicate who will receive your assets when you die. A trustee manages the trust and ensures the correct individuals receive their benefits in the event of your death. You can also create an irrevocable life insurance trust if you want to reduce estate taxes and leave a larger inheritance.
• Name an adult custodian for the life insurance proceeds under the Uniform Transfers to Minors Act.
• Consult an estate attorney to decide the best course of action.

Listing a lifelong dependent who could lose government benefits

When it comes to distributing life insurance money to a lifelong dependent, it's important to consider the potential impact on their government benefits. In some cases, receiving a lump sum of money from a life insurance policy could disqualify them from certain means-tested government assistance programs. Here are some key points to consider when listing a lifelong dependent who may be at risk of losing government benefits:

• Understanding Dependent Qualifications: The definition of a dependent can vary depending on the insurance provider and the specific plan. Typically, dependents include spouses, biological children, adoptive children, stepchildren, and in some cases, parents or siblings. It's important to carefully review the eligibility criteria of your insurance plan to ensure your lifelong dependent meets the qualifications.
• Government Benefits Considerations: Different government assistance programs have varying eligibility requirements. For example, means-tested programs may consider the recipient's income or assets when determining eligibility. If your dependent receives means-tested benefits, a sudden influx of money from a life insurance payout could potentially disqualify them. It's important to consult with a financial advisor or benefits specialist to understand how the life insurance distribution will impact your dependent's specific government benefits.
• Special Circumstances: If your lifelong dependent has special needs or disabilities, they may be eligible for extended coverage under certain insurance plans. In such cases, you may need to provide documentation of their condition and demonstrate their reliance on you for financial or medical support. This could impact the amount and duration of their government benefits, so careful consideration is necessary.
• Tax Implications: While life insurance proceeds received by a beneficiary due to the death of the insured are generally not taxable, there can be tax implications in certain situations. For example, if the policy was transferred for cash or other valuable consideration, the exclusion for proceeds may be limited. Additionally, if your employer-provided life insurance coverage for your dependent exceeds a certain amount, the full policy amount may be taxable as imputed income. Understanding the tax consequences can help you make informed decisions about distributing the insurance payout.
• Alternative Options: If you are concerned about the impact of a lump-sum payout on your dependent's government benefits, consider exploring alternative options. You may be able to set up a special needs trust or an ABLE account, which are designed to hold assets for individuals with disabilities without disqualifying them from means-tested government benefits. Consult with a financial planner or attorney to determine the best approach for your specific situation.
• Seek Professional Advice: Navigating the complexities of life insurance distributions and government benefits can be challenging. It's highly recommended to consult with a qualified professional, such as a financial advisor, attorney, or benefits specialist. They can provide personalized advice based on your specific circumstances and help you make informed decisions that balance the financial needs of your dependent with the preservation of their government benefits.

Not working with your spouse in a community-property state

If you live in a community-property state, it's important to understand how this affects your life insurance planning. Community-property states view married couples as joint owners of almost all assets and debts acquired during the marriage. This means that if you use money earned during your marriage to pay your life insurance premiums, your spouse may automatically be entitled to a percentage of the death benefit, even if they aren't listed as a beneficiary.

There are currently nine community-property states in the US: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In these states, it's crucial to work with your spouse when deciding on life insurance beneficiaries. If you designate anyone other than your spouse as the beneficiary, they will need to waive their rights to the money. This is a right that your spouse can exercise even after your death, so it's important to have their consent before finalising your policy.

To avoid this situation, you can choose to pay your life insurance premiums with separate funds, such as an inheritance or money from a personal account. This way, the policy won't be considered marital property, and you can name beneficiaries without your spouse's waiver. However, if you use a joint account to pay premiums with inherited funds, the policy may still be considered marital property.

Additionally, keep in mind that community-property states vary in their treatment of income from separate property. In some states, this income is considered separate property, while in others, it is viewed as community property. This can impact how the ownership of life insurance policies is determined.

If you live in a community-property state and want to designate someone other than your spouse as your life insurance beneficiary, it's essential to consult with a legal professional to ensure you're complying with the specific laws of your state. They can guide you through the process and help you structure your policy to match your intentions.

Falling into a tax trap

While life insurance proceeds are generally tax-free, there are some common pitfalls that can result in your beneficiaries having to pay taxes on the money they receive. Here are some of the most common tax traps to be aware of:

Three People on a Life Insurance Policy

If the owner, the insured, and the beneficiary are three different people, the death benefit may be treated as a taxable gift from the policy owner to the beneficiary. This is known as the "unholy trinity" or "the Goodman Triangle", named after a 1946 court case, Goodman v. Commissioner of the Internal Revenue Service. To avoid this, ensure that two of the three roles are filled by the same person.

Three People on a Policy in a Business Situation

In a corporate-owned policy with personal beneficiaries, the death benefit may be treated as taxable compensation for the employee or as a dividend for a shareholder. This can be avoided by using an endorsement split-dollar arrangement, where the business owns the policy but the employee names a personal beneficiary, or an executive bonus plan, where the business pays the premiums for a policy personally owned by the employee.

Exchange of a Policy Encumbered with a Loan

Exchanging one life insurance contract for another can trigger unwanted tax consequences if there is an existing loan on the original policy. The loan amount may be treated as ordinary income up to the amount of the policy's gain. One solution is to arrange for the new policy to take over the existing loan, as this maintains your economic position and avoids a gain.

Gift of a Policy Encumbered with a Loan

When gifting a life insurance policy, if the policy is subject to a loan, the transfer relieves the original policy owner of the debt. As the donor is deemed to have received an economic benefit, the transfer is treated as if the policy were sold, and the donor may recognize taxable income.

Lapsing a Policy Encumbered with a Loan

Permanent insurance policies offer the benefit of taking out a policy loan without financial qualification. However, if the loan is not repaid before the death of the insured, the money will be withdrawn from the insurance death benefit before it is distributed to the beneficiaries. To avoid this, monitor the policy closely and ensure any loans are repaid.

Taking a Life Insurance Policy Withdrawal in the First 15 Policy Years

Withdrawing from a universal life or variable universal life policy within the first 15 years will be treated as coming from gain first, which can result in unexpected taxes. Some insurance companies allow for withdrawals of up to 10% with no reduction in the death benefit. Alternatively, consider structuring the withdrawal as a loan, weighing the long-term cost against the potential tax associated with a withdrawal.

Incorrectly Structured Cross-Purchase Policies

If life insurance purchased to fund buy-sell plans is not properly structured, it may have unwanted tax consequences. In a cross-purchase buy-sell arrangement, each business partner owns a policy on the other partners, and the survivors use the insurance proceeds to buy out the deceased's estate. Any other arrangement can fall into the "transfer-for-value" trap, where the death benefit is no longer fully income tax-free. To avoid this, ensure the policy is transferred to the insured, a partner of the insured, a corporation in which the insured is a stockholder, or a bona fide gift such as a spouse or trust of the insured.

Assuming your will overrides your life insurance policy

A will is a legal document that outlines your final wishes and how your heirs will receive your assets after your death. It's important to have a will to ensure your assets are distributed according to your preferences. However, when it comes to life insurance, the beneficiary listed on the policy will receive the death benefit payout, regardless of what your will says. This means that assuming your will overrides your life insurance policy can be a costly mistake.

To avoid this mistake, it is crucial to regularly review and update your beneficiary designations, especially after major life events such as marriage, divorce, or the birth of children. You should also be as specific as possible when naming beneficiaries. Instead of simply saying "my children", list their names, Social Security numbers, and addresses. This will help ensure that your life insurance money is distributed according to your wishes.

In addition, it is important to understand the different ways of distributing life insurance proceeds. You can choose to have the money divided by branch of the family (per stirpes) or by head (per capita). Working with a qualified insurance professional or an estate planning attorney can help ensure that your life insurance proceeds are divided according to your intentions.

By taking these steps, you can make sure that your life insurance policy and your will work together to provide a comprehensive financial safety net for your beneficiaries.

Frequently asked questions