Proper Beneficiary Designations for Life Insurance

Many people own life insurance policies, either through their employment or as supplements to their employer-funded policies, or have individual retirement plans (IRAs) or employee benefit plans (usually 401(k) plans), but unfortunately, not much thought is given to the beneficiary designations for those policies or retirement plans. The typical designation will go something like this:

Primary Beneficiary: My surviving spouse

Secondary Beneficiary: My children

The problem with simple designations such as the above is that if you have a substantial estate or if you have minor children, you can be creating complicated situations for them in the future. For example, let’s say husband and wife are killed in a car accident. They each have insurance policies naming the other spouse as the primary beneficiary. They have two young children, who are 4 and 2 years old, listed as the secondary beneficiaries. The insurance company will not pay out the proceeds to the minor children because they do not have the legal capacity to accept the money. Because of the way the designation is made, the company’s only alternative is to pay the funds to a guardian of the estate for the minor children. A guardianship is a costly and time-consuming process that severely constricts the use and investment of the funds and requires that all a minor child’s share of the proceeds must be given to that child when they turn 18, when they are typically still financially irresponsible.

In addition, if you have a large enough estate, and you have prepared trusts under your Will to protect your exemption against estate tax (known as a “bypass” trust or “credit shelter” trust) or to provide trusts for your children for their future protection, and you planned on funding these trusts with the proceeds from the life insurance, you should be aware that for the tax and other planning contemplated by your Wills to work effectively, much of your property, other than qualified plans and individual retirement accounts (designations for these plans will be discussed in a future post), should pass under your Wills at your deaths. To the extent that you use “probate avoidance” methods of transferring your property at your deaths, some of your property may pass outside the provisions of your Wills (such property is referred to as non-probate property), and you could be circumventing the tax and other planning accomplished under your Wills. Some common types of non-probate properties are those that pass by beneficiary designation (insurance, annuities, individual retirement accounts, etc.) payable on death accounts (also known as “POD” accounts), joint tenancy with rights of survivorship accounts (also known as “JTWROS” accounts), revocable trusts and community property survivorship agreements. Accounts with payable on death beneficiaries or accounts which are held as joint tenancy with rights of survivorship can be convenient ways to dispose of small bank balances if properly handled, but if large amounts are involved, your estate plan could be seriously disrupted. Unless you have non-tax reasons for establishing survivorship accounts, survivorship agreements or payable on death accounts, as a general rule, you should avoid doing so, and you should change any such accounts that you may have previously established to joint accounts held as tenants in common (sometimes referred to as accounts with “No Survivorship”). This will help to ensure that such property does pass under your Will and to the beneficiaries named in your Will or into trusts created under the Will.

The importance of making sure that the death beneficiary designation on your life insurance and similar products like annuities is properly coordinated with your estate plan cannot be overemphasized. One way for you to designate the beneficiary on life insurance policies and annuities is as follows:

Primary Beneficiary: 100% Insured’s spouse

First Contingent Beneficiary: 100% Testamentary Trustee designated in the Insured’s last will and testament

By having it paid to the surviving spouse, the spouse has the right to either accept the assets outright, or if there is a trust created under the Will to protect against the possibility of estate taxes, the spouse can disclaim any or all of the proceeds, and let the proceeds pass to the bypass trust, of which the spouse is usually the beneficiary. The benefit is that while the spouse still can benefit from the policy proceeds, the proceeds will not be counted as part of his or her estate for estate tax purposes when the surviving spouse dies.

If the husband and wife die simultaneously, then the proceeds would automatically be paid to the contingent beneficiary—the Trustee for any trusts created under the Will for descendants of the husband and wife.

If all the children are adults, you can name them as contingent beneficiaries (or if you are unmarried, as the primary beneficiaries). But what if a child predeceases you? Do you want his share to pass to his children, or to your surviving children only? If you want it to go to your surviving children only, then the following designation (or something similar) should be used:

“In equal shares to my children who survive me”

If you want children of any deceased child to receive that child’s share, then you could use the following designation instead:

“To my descendants then living per stirpes”

Per stirpes is a term that essentially means that a deceased child’s share will pass in equal shares to his children. For example, let’s say you have three children. Each child, if they survived you, would receive a 1/3^rd share of the proceeds. However, if one child predeceased you leaving two children, then those two children would get ½ of the deceased child’s 1/3^rd share (or 1/6^th each). The two surviving children would still receive their 1/3^rd share.

The danger, of course, in using the above designations is that you might wind up with some minor beneficiaries and have the guardianship issue arise again. In such a situation, where you have trusts created under your Will for your descendants, the better choice may be to name your estate as the contingent beneficiary. In that scenario, the minor descendants’ share will be held in trust without the necessity of a guardianship.

The beneficiary designations listed above are by no means exclusive. You may have a list of persons you want to name as beneficiaries of your life insurance other than just your children. Further, you should be aware that naming your estate (as opposed to the Trustee under your Will) as the beneficiary of your life insurance can expose those assets to the creditors of your estate, if any creditors exist upon your death. For most people, this is not a concern, but because the above designations may not always be appropriate in every situation, before executing any new beneficiary designations you should check with your attorney or financial planner about the best way to style the designations. Spend some extra time making sure that the designations you use don’t conflict with the estate plan that you have in mind. You may create problems that you can easily avoid.