Life Insurance Choices
Dec. 2, 2019
It is such a simple question when you are completing a life insurance policy application. Who do you want to receive the death benefit in the event of your death? But there are many pitfalls on the way to a "correct" answer. For example, if you are a single person when the policy is purchased (or coverage is first extended in the case of an employer's group term policy), are you going to remember to change it when you get married?
I once had a case where, five years after the wedding, a man was sure that he had changed the "beneficiary card" at his place of work to replace his mother with his wife. After his tragic death in an accident later that year his widow discovered that the change had never been officially made and the card still listed her mother-in-law. After a lawsuit, she was only able to obtain (through negotiations) a small fraction of the death benefit. She settled out of court because there was a high risk that she would receive nothing.
That should be an easy mistake to avoid. The more subtle mistake involves the parents of minor children who designate those children as contingent beneficiaries of hundreds of thousands of dollars of life insurance (with the spouse as primary beneficiary). In the event of the simultaneous death of both parents, there is no surviving spouse to receive the death benefits.
However, the life insurance company cannot legally pay the money directly to a minor. It must be turned over to a conservator of the property to hold until the child reaches 18 years of age. During that time it can only be invested in bank deposits and government securities unless prior court approval is obtained.
There are two things wrong with this picture. First, most parents would like to delay the receipt of a large inheritance until at least after a child has completed college or is older than 18 years of age. Second, the investment of the insurance proceeds in more productive investments might be appropriate so that it will grow significantly faster than the rate of inflation.
Both of those objectives can only be achieved through the use of a trust, where written authority is given by the parent (either through a Will or through a trust agreement) to an individual and/or a corporate trustee to hold the property, invest it and use it for the benefit of the child until a designated age when it is to be distributed in total or in installments.
Such a trust for the children does not have to be a free-standing trust. It can be a testamentary trust which receives the death benefit either directly from the life insurance company (with a carefully drawn beneficiary designation) or from the executor of the estate (when the estate is the secondary beneficiary but the will directs the distribution of the estate's property to the trustee).
Life insurance can also add to a person's wealth sufficiently that they must worry about the Federal Estate Tax, which starts at 35% on every dollar above $5 million that does not pass to a surviving spouse or charity. That "exempt amount" is fixed for 2011 and 2012. The "smart money" is betting that somewhere around January 1, 2013, Congress will pass a law to freeze the exempt amount at that level.
Estate tax avoidance for large life insurance policies is fairly straight forward when a married couple utilizes tax-oriented trusts in their estate plan. Each spouse protects some property from such death taxes by leaving it in trust instead of outright to the surviving spouse. With the right contingent beneficiary designation and a series of disclaimers, all or some of the life insurance can go to the trust, of which the spouse is a trustee. At the death of the surviving spouse, that trust money is not subject to the estate tax and passes to the children at the appropriate ages chosen by their parents.
Finally, when a person has what we might call "mega-wealth" and wants to maintain life insurance, the most tax-efficient method can be to establish an irrevocable trust which purchases and pays for that life insurance. The founder of that trust donates sufficient money to it each year for payment of the premiums. This is a fairly complex solution and should only be done with the assistance of an experienced attorney and a good life insurance agent.
Life insurance is too important (when it is needed) for mistakes to be made. Be careful out there