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Understanding Life Insurance Beneficiaries

Researcher & Writer
April 06, 2018

Most people don't put much thought into choosing a life insurance beneficiary. Unfortunately, this can create a major problem for your heirs. As a result, TermLife2Go put together this article to help you navigate the potentially stormy waters involved in naming primary and contingent beneficiaries.

How life insurance beneficiaries work

You can name up to three levels of beneficiaries for your life insurance policy on your beneficiary designation form. Typically, when filling out the designation of beneficiary form, you will need the beneficiary's personal information, such as their social security number, date of birth, address and phone number. You will also have the option of naming a testamentary trust (i.e. a Will), living trust, a business entity (need tax ID or EIN) or the Insured's estate.

The first level of beneficiary is called the primary beneficiary.Your primary beneficiary is defined as the person or organization that your lump-sum death benefit will go to when you die. You can name one primary beneficiary or many primary beneficiaries. If you name more than one, the death benefit will be distributed in an equal share to all named beneficiaries.

For example, you can name a non-profit organization as the primary beneficiary of your life insurance death benefit. Or, you can name your three kids, or your five nieces and nephews, or ten grandchildren, etc. There is no set rule on how you divvy out your death benefit to your beneficiaries, although certain restrictions may apply from one life insurance company to the next.

And you can also designate different percentages for each beneficiary, so that one beneficiary may get more than another. There is also typically a spot to check that says you want all your children to receive per stirpes, which is Latin meaning "by branch" so that if a child predeceases you with issue (i.e. they have a kid) then the predeceased child's share passes to your grandchild.

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What if your primary beneficiary should die before you?

If the primary happens to predecease you, and you do not have other primary beneficiaries listed, then the proceeds will flow to the contingent beneficiary or contingent beneficiaries. A contingent beneficiary is defined as the person or organization who would receive under the terms of the life insurance policy if the primary beneficiary cannot or chooses not to receive the death benefit proceeds. So, the contingent beneficiary would be considered the secondary beneficiary.

And there is even one more level of protection you can add. If your contingent beneficiary predeceased you as well, then a third beneficiary, called the tertiary beneficiary, will receive the life insurance death benefit proceeds. A tertiary beneficiary would be defined as the beneficiary of the proceeds should the primary and contingent beneficiary not take.

When to update your Primary or Contingent Beneficiary

There are certain life events that require you to take action and make sure your life insurance beneficiary is up to date. These life events include divorce, remarriage, the birth of a new child, and the death of a child.

Some examples of when to update your life insurance policy's beneficiary include:

  • Getting married
  • Upon a divorce
  • Getting remarried
  • New baby arrival
  • Buying a home
  • Death of a beneficiary
Don’t Keep it a Secret!

So, what steps need to be taken in order that your primary or contingent beneficiary can collect on your life insurance death benefit?

Step one would be to let your primary and contingent beneficiaries know about your life insurance. Alternatively, you can refer to your policy in your will or trust documents, and maybe even leave a copy with your attorney. The point is, make it easy to find your policy so your beneficiaries can actually collect.

Step two would be for your primary beneficiary or his or her agent to contact the life insurance company for information on filing a life insurance death benefit claim.  Most companies have a very easy and streamlined process. And the typical turnaround to receive the death benefit after filing a claim is around 30 days.

Who should I name as my primary beneficiary?

The normal primary beneficiary is typically your husband or wife. They would be the person who you want to receive the life insurance benefit. If you name someone other than your spouse, know that certain rights are extended to your spouse in a community property state, which includes 1/2 ownership of all your community property assets. You spouse may have a legal right to the life insurance benefit, even if you do not name them the beneficiary if you used community property money to pay the policy's premiums.

The contingent beneficiary is often your children. However, naming a child as a beneficiary can create some problems and require court interaction if you have not planned ahead. More on this in a moment.

Another option people elect is to name a charity or nonprofit organization as the primary beneficiary with the contingent beneficiary being a loved one or another charity if the original beneficiary organization no longer exists.

Also, be aware that different states and insurance companies view a common-law partner differently. A common-law spouse is a spouse that you have not officially married through a typical ceremony, but who you hold out to be your spouse to friends and family. Just because you have a common-law marriage, don't make the assumption that your common-law spouse will automatically receive the death benefit unless you specifically name him or her as your primary beneficiary.

Naming a minor as your life insurance beneficiary

When you name a minor as a beneficiary you need to be aware that the minor will not be able to receive the proceeds until the minor reaches 18 years of age. In the mean time, the funds from the insurance will be placed into a trust account to be managed by a guardian. If you have not made a decision in advance on who will be the guardian of your child then the court will assign a guardian or conservator on your child’s behalf.

The best way to avoid having unnecessary court interaction is to create a will that designates in advance who the guardian of your child will be. You can also create a Living Trust that names the trustee of your estate.

Trustee vs Guardian

The guardian will have custody of your child and the trustee will have control over the money in your estate.

The trustee will then be authorized by your trust on how to take care of your child financially. You can name the same person as guardian and trustee or you can assign different people to the positions. The advantage of assigning different people to act is that there are more checks and balances, forcing the guardian to be accountable for how money is spent and vice versa.

Designating your trust as the beneficiary

A great route to take when deciding on who should receive the proceeds of your life insurance is designating your living trust as the life insurance contingent beneficiary with your spouse as the primary beneficiary. This is typically done by naming the current acting trustee of the trust as the contingent beneficiary.

You see, in doing so, your life insurance proceeds will flow, first to your spouse, and then into your trust upon your death if your spouse predeceased you. The life insurance will then be distributed according to the terms of your trust.

So, your trust controls how the funds are distributed and you do not have to worry about trying to create an equal distribution of your estate among your children because your trust has already been set up to do so.

Another advantage besides an equal distribution according to the terms of your trust is that you can also designate in your trust at what age your children will receive the trust proceeds.

With a will or with life insurance your primary beneficiary will typically receive the full inheritance at age 18. That means your child or children will be running around at 18 with essentially a blank check. That is not the best plan if you truly care about your child’s future. Instead, your trust can determine the age or ages that distribution will occur.

For example, a trust can be set up so that your beneficiary receives a portion at age 22, 25, and the remainder at 30. This way your beneficiary can learn some valuable life lessons. They might blow through the money they received at 22 but by the next distribution they will have (hopefully) learned that they need to take better care of their inheritance.

Naming your estate as the beneficiary

If you leave your life insurance to your estate you could be inviting a world of hurt to your heirs. The problem is different states have different rules when it comes to what asset level an estate must have in order to be required to enter into probate.

And probate can be expensive. In some states, probate can cost your estate 4-6% of the estate's total assets. This is due to the fact that attorney fees, CPAs, and appraisal fees take a huge amount of estate assets.

For example, in California, the threshold for a probate of an estate is $150,000. That means that if your estate has assets in excess of $150,000, your estate will go through probate.

And in California, the fair market value of the home and not the net value of the home is what the court considers. That means if your home is worth $250,000 but the net value (home value – mortgage) is only $25,000, the home will still be worth $250,000.

As a result, you would be subject to probate and the accompanying fees on the full $250,000 home value, even though your actual net worth in the home is only $25,000!

The good news when it comes to life insurance is that it is generally considered a non-probate asset. The funds from the life insurance will go directly to your primary beneficiary named in your life insurance policy. Or if they are not alive, then to your contingent beneficiary.

But if you leave the funds to your estate then the estate may be forced into a costly probate, taking a lot of the assets away from your heirs and giving it to attorneys, accountants, and appraisers.

The better route to take may be to name your spouse as your primary beneficiary and the trustee of your trust as the contingent beneficiary or your spouse and kids. Don’t however name your estate as the beneficiary as this can cause all sorts of money issues.

As with anything dealing with law and taxes, please consult with your attorney or tax advisor on how to properly structure your life insurance policy and estate. Our advice is general in nature and should not be construed as legal advice or pertaining to your specific situation.

Naming a business partner as your beneficiary of your life insurance

Another way that life insurance can be used as a great estate planning tool is by naming your business partner as the primary beneficiary.  You can structure a buy sell with life insurance so that your death benefit goes towards buying your family out your interest in the business. Then your business partner, or you, are free to proceed with business as usual without the new family members "joining" you in the decision making.

Naming a charity as the beneficiary of your life insurance

If you are single or if you desire your assets go to a charity, then a great way to accomplish this is to name a charity as the primary beneficiary of your life insurance. However, it is a good rule to name another charity as the contingent beneficiary in case the original beneficiary organization no longer exists.

Life insurance beneficiary and second marriages

If you are in a new marriage and you have kids from your previous marriage then you may want to list your kids as the primary beneficiaries. The best way to do this is to set up a trust that will take care of the money while your kids are minors. You can research a Qualified Terminable Interest Property Trust (QTIP) for more information. Otherwise, your new spouse may not be so inclined to share with your kids upon your passing.

Death Benefit and Taxes

In most cases, the lump sum death benefit from life insurance is not taxable. However, there are instances when the insurance benefit may be taxed, such as when there is a different owner, insured and beneficiary. Also, if the death benefit is paid out through installments, the interest growth of the death benefit is taxable. Finally, see the Transfer for Valuable Consideration rule under IRC §101(a)(2). Consult your tax advisor for more information.

In addition, life insurance may be subject to estate taxes if the life insurance pushes your estate over the current federal exemption of $5.60 million in 2018 or over your current state exemption level, which varies state to state.

You see, it is important for those who have larger estates that exceed the exemption level. If you happen to fall into this category, please seek out advice from a financial planner and an estate planning attorney on how you can structure your life insurance to benefit your estate and not add additional taxable assets.

Now for those of us whose estates fall below the current exemption level of$ 5.6 million or $11.2 million for a married couple, there are several factors that still need to be considered when choosing a beneficiary for life insurance.

Insurable Interest

The main ingredient that a life insurance underwriter is looking for when reviewing a life insurance beneficiary is insurable interest.

A life insurance insurable interest exists when there is a financial loss to the beneficiary. A life insurance company will look into whether the beneficiary has an insurable interest in the life of the proposed insured. If there is no insurable interest the life insurance company may choose not to offer insurance.

An example of an insurable interest is a husband or wife who is the primary bread winner. If the primary bread winner were to die, the family he or she leaves behind would suffer a direct financial loss. Thus, the primary beneficiary of the husband or wife has an insurable interest.

An example where no insurable interest exists is when someone wants to leave money behind to a friend. If the primary insured dies, there is no economic loss to the friend. A life insurance company might choose to deny life insurance in this case due to the outside chance that some sort of harmful act could occur, such as the friend deciding to murder the primary insured.

Your life insurance beneficiary is not set in stone

You can always change the beneficiary of your life insurance by filling out a change of beneficiary form.

The exception to this would be if you set up an irrevocable life insurance trust. As the primary insured and Settlor of the ILIT, you would not want to grant yourself the ability to make changes to the Irrevocable Trust. This could cause some serious consequences to the validity of the irrevocable life insurance trust. There are work around to this and a good estate planning attorney would be able to instruct you of all the potential pitfalls. But apart from an ILIT, the person who you name the beneficiary today does not have to be the person who becomes the beneficiary down the road.

One word of caution though. There have been cases where a beneficiary has been deemed to not have an insurable interest and the life insurance proceeds went to a different party than the beneficiary listed upon the death of the insured. The key would be that if you decide to change the beneficiary of your life insurance, make sure the beneficiary has some sort of insurable interest. Otherwise, there may be potential for a family member to attack the validity of the beneficiary in court.

Why would a court allow this? The main reason a court might invalidate a beneficiary would be where there is a question of undue influence or duress. An example might be an older man who removes his children as beneficiaries in favor of his care taker.

What if my life insurance beneficiary takes my life?

In the horrible event that your life insurance beneficiary decides to take your life in order to collect on the life insurance proceeds, the law is pretty straightforward that the murderous beneficiary, as well as any conspirators, would not be able to collect the death benefit.

The bottom line

The main point of all this is that TermLife2Go knows a lot about primary and contingent beneficiary designations and life insurance. We are here to answer any questions you may have.

As with anything dealing with law and taxes, please consult with your attorney or tax advisor on how to properly structure your life insurance policy and estate. Our advice is general in nature and should not be construed as legal advice or pertaining to your specific situation.

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