If you're designating life insurance beneficiaries on a life insurance policy, avoid these common mistakes. Learn the answer to "what is a trust" and more.
A life insurance policy is vital protection to have if there is anyone in your life who depends on your income. Parents, spouses, and individuals who are taking care of aging parents can protect those they love financially with a life insurance policy.
Life insurance is also beneficial to business owners, homeowners, and those that have student loan debt. When you die and have a life insurance policy in place, your life insurance will pay your life insurance beneficiaries your benefits.
You've worked hard throughout your life to earn income. The value of what you've earned shouldn't be cut short after you've passed on. However, by making a mistake when naming life insurance beneficiaries, your earnings may be passed on to the wrong person, get tied up for months or years in court, or decrease in value1 due to complications.
Getting a life insurance policy is important, but it's only as effective as the life insurance beneficiaries you name. Here are six mistakes to avoid.
1. Not Keeping Your Life Insurance Policy Up-to-Date
First thing's first: If your life insurance policy is not current, then you may accidentally leave your benefits to a party you no longer want to. If you divorce or remarry but still have your ex-spouse as your beneficiary, this could be an immense mistake.
Update your life insurance policy whenever there is a major life change involving you and your family. This includes if you insured a minor child who is now an adult with a spouse and children. Not doing so could lead to your adult child's family not receiving financial support should the unthinkable happen to you, your spouse, and your adult child.
2. Not Leaving Instructions for How Money Should Be Dispersed
It's crucial to include instructions for life insurance benefits dispersal once you've passed. Not doing so poses many risks, including:
- The money could get tied up in probate - Probate is court proceedings that determine how your assets will be distributed2 to your heirs. If you don't want to leave this to a judge to decide and potentially mismanage according to your wishes, you need a plan in place.
- You could leave large sums of money to financially irresponsible beneficiaries - For example, leaving a lump sum of hundreds of thousands of dollars to a 21-year-old may result in your benefits being misspent.
- A guardian could mismanage your money - If you leave your life insurance benefits to a guardian in charge of your kids, the guardian could spend all the money before your kids reach legal age. What they spend it on may not be worthy of what you intended.
Setting up a trust3 helps you avoid these pitfalls. What is a trust, you ask? A trust is an arrangement where another party, known as the trustee, is designated to be in charge of finances and properties that are to be distributed to beneficiaries. A trust outlines when and to whom specific assets will be distributed.
A trust eliminates the need for probate, which protects the finances of the deceased, since court costs are eliminated. Probate can also be time-consuming and create conflicts among loved ones the deceased leaves behind.
3. Designating Only a Primary Beneficiary
Naming only one beneficiary puts your insurance proceeds at risk, should both you and the primary beneficiary pass away. The primary beneficiary may die before you do, and if you don't update the policy, there will be no named beneficiary. If you both die together in an accident, the same problem occurs.
Make certain to name secondary and tertiary life insurance beneficiaries. Not having a beneficiary in place means your benefits will typically go to your estate. Then, they're subject to probate. Estate creditors may also be able to claim your benefits when there is no named beneficiary.
4. Naming Your Estate as Beneficiary
Again, when your benefits go to your estate, they are subject to probate. Not only can they dwindle in the court process, but in the end, they may go to the wrong party or be seized by probate and/or estate creditors.
Payout by probate can be delayed by a year or more. In the meantime, as your loved ones are grieving your loss, they also may be stressed out from arguing with each other about your benefits. Having a trust in place ensures your legacy is distributed exactly how you want it to be. This can help boost the peace of mind for those you leave behind.
5. Naming Minor Children as Beneficiaries Without a Trust
Most insurance carriers will not pay benefits directly to an underaged child. This makes sense — how would you expect a 7-year-old to manage potentially tens of thousands of dollars or more?
When a legal guardian passes on and has minor children listed as life insurance beneficiaries without a trust in place, the courts will:
- Pass on benefits to a guardian appointed by the deceased
- If there is no guardian appointed, first appoint one, then pass on benefits
Both cases make your benefits vulnerable. If you did not appoint a guardian to manage the money, the court selection of a guardian could create tension, complications, and a delay before your beneficiary receives financial support. As mentioned, any guardian who is also in control of your money may mismanage it.
The best scenario is to create a trust for minor beneficiaries. You can designate exactly how that money will be used — for college, for example — and then also designate intervals when the money will be dispersed.
For example, you may decide to distribute portions of your benefits once your child reaches ages 25, 30, 35 and so on. This way, your child has access to smaller amounts of money at a time, which may help them manage it better.
6. Selecting a Beneficiary Who Is Dependent on Government Assistance
A large financial inheritance may disqualify a disabled or otherwise dependent person from receiving further government benefits. The government may seize the beneficiary's payout as reimbursement for benefits paid. You think you're helping someone with special needs, when really this life insurance policy mistake could hurt them financially.
You can create a “special needs trust,” which enables you to support your special needs child or dependent without disqualifying them from receiving government assistance.
A Trust Can Help Ensure Your Life Insurance Benefits Are Well-Distributed
Life Insurance can help protect the finances of your loved ones should you pass on, but only if you name the right beneficiaries and protect them through a trust. Creating a written will is not enough to avoid probate, court costs, and potential complications to your benefits. A living trust enables you to make necessary changes while you are still alive, and it helps you protect your finances — and the sanity — of your loved ones.
If you have any questions about how life insurance works, we're here to help. Contact AIG Direct at 800-294-4544 for life insurance policy information.
This information is general in nature, may be subject to change, and does not constitute legal, tax or accounting advice from any company, its employees, financial professionals or other representatives. Applicable laws and regulations are complex and subject to change. Any tax statements in this material are not intended to suggest the avoidance of U.S. federal, state or local tax penalties. For advice concerning your individual circumstances, consult a professional attorney, tax advisor or accountant.