Who Should Your Client Name as a Beneficiary?

Americans pay hundreds of billions of dollars in life insurance premiums per year. Most policyholders will never see a payout themselves. Instead, it will go to their loved ones to provide for them when the policyholder dies. 

Life insurance benefits and claims totaled $797.7 billion in 2022, including more than $88 billion in death benefits, according to the Insurance Information Institute. The typical life insurance payout is approximately $168,000. 

If a policyholder designates a beneficiary on their life insurance policy, the death benefits are not typically part of a decedent’s estate that goes through the probate process because they pass directly to beneficiaries. However, the potentially large cash value it can provide makes it central to estate planning and requires careful consideration about how to structure the beneficiary designation. 

Naming a Spouse or Children as Beneficiaries

The most common beneficiaries of a life insurance death benefit are a surviving spouse and/or children. 

Life insurance death benefits are typically protected from creditor claims for policyholders’ debts. But once the designated beneficiary receives the death benefits, the beneficiary’s creditors can go after the funds to satisfy the beneficiary’s debts—even debts owed jointly with the deceased policyholder (for example, an outstanding loan or credit card debt where the policyholder and the spouse are co-signers). This is true whether the beneficiary is the policyholder’s spouse, child, or other loved one.  

The death benefit of the life insurance policy may also be open to claims of the named beneficiary’s spouse. If a surviving spouse beneficiary remarries or a child beneficiary divorces, for example, the death benefit proceeds received by the beneficiary and put into one of their accounts or investments could end up being categorized as marital assets and, therefore, subject to equal division in the event of a divorce. This outcome could countermand the intention of the policyholder. 

If no beneficiaries are named on an insurance policy or if the beneficiary named is the policyholder’s estate, then a probate estate will likely need to be opened to administer and transfer the death benefit to the policyholder’s heirs or beneficiaries. Once the probate estate has been opened, the deceased policyholder’s creditors may have an opportunity to claim the death benefit before the funds are distributed to the heirs or beneficiaries of the estate. 

Minor child beneficiaries present challenges as well. Insurance companies cannot pay insurance proceeds directly to minor children. An adult will usually have to be appointed to manage the funds until the child reaches the age of majority. Depending on your state, this may involve a court proceeding and annual reporting requirements that cost money and can delay the payout. 

Some life insurance policies allow a custodian to be assigned to a minor child beneficiary without needing a probate court appointment. A custodian manages the money for the minor child until they reach legal adulthood, when the assets are turned over to them. 

Naming a Charity as Beneficiary 

A life insurance policy can be a way to make a charitable gift at the end of life. This option might appeal to a client who purchased a policy to protect a spouse or children who no longer need it, to complete payment of a mortgage, tax, or other debt that is no longer a concern, or to cover some other contingency that no longer requires the funds a life insurance policy would have provided. 

A life insurance policy can also be purchased for the express purpose of charitable giving. In addition to taking out a new policy to benefit charity, a charitable recipient can be named as a beneficiary on an existing policy to receive all or part of the policy proceeds. Other options include transferring ownership of a policy to a charity and gifting dividends from a life insurance policy to a charity. 

Each of these options can provide tax benefits. Depending on how a life insurance gift is made, the cash value of the policy, the cost of premiums paid, or the value of dividends may be deducted. 

Creating a Trust for a Loved One

Naming individuals as life insurance beneficiaries can provide convenience and flexibility for beneficiaries because the money passes to them quickly and easily outside of probate. The beneficiaries only need to file a claim with the life insurance company and select how they want the death benefit to be paid (usually in periodic payments or a lump sum). 

However, there are downsides to setting up a death benefit in this way. The policyholder ultimately loses control over how the insurance proceeds are used. They may have intended to protect their loved ones financially—but if they are deceased and the funds are in the hands of their beneficiaries with no controls or restrictions, can they ensure that the benefit is used in accordance with their wishes?  

They can. Policyholders can control the death benefits of their life insurance policy by naming a trust they have set up as the policy’s beneficiary and allowing a trustee to manage the death benefit on behalf of trust beneficiaries, such as a spouse or children. This arrangement allows the client to provide instructions about how the money should be used and managed. 

A trust can be useful for leaving money to underage or special needs children. It can also ensure that a disabled beneficiary remains eligible for government assistance or keep a young adult from spending the funds all at once. Insurance proceeds held in trust are also protected from creditors and exempt from probate. 

Advising Clients on Life Insurance 

About 90 million American families rely on life insurance for financial protection and retirement security. However, recent survey data indicates that more than 100 million Americans are facing a life insurance coverage gap, presenting an opportunity for advisors to steer them toward these products. 

As a value add, advisors can explain how life insurance fits into an estate plan and walk them through the different options for naming beneficiaries. These discussions could open new revenue streams, such as establishing trusts and charitable donations. 

Please contact our team for a primer on life insurance and estate planning and how our practices can benefit each other.