How to Handle a Life Insurance Policy

How to Handle a Life Insurance Policy

You’re one step ahead of everyone else in this crazy game called life: you’ve made an estate plan to distribute your assets after you die. Great job, and…now what? What do you do with those assets to ensure that they are distributed as you planned in your Will or Trust?

We often get questions about how to handle a life insurance policy. Since life insurance benefits are tax free when they are paid from one spouse to another, it makes more sense to keep the title of the policy under your own name rather than having the policy owned by a Living Trust. However, since it’s often a large amount (think between $250,000 and $1,000,000) the assets in a life insurance policy may trigger a probate if they aren’t properly designated to your heirs, even if the assets are assigned to them in the Will itself (see our post on What a Will Won’t Do for a more detailed explanation of this point).

So…how should you handle your life insurance policy?

Use a Beneficiary Designation Form

This is a document that lists the individuals who should receive whatever payout you have bought with your life insurance policy. Whenever possible, use the life insurance company’s own Change of Beneficiary form. It’s a good idea to ask for a date-stamped copy of the change from the insurer’s home office that confirms acceptance of the beneficiary designation. Keep it with your estate planning documents as proof of the designation.

Below are some suggestions for Colorado residents based on whether you have estate planning documents and, if so, what type, along with what people usually want to have happen. But this advice can differ depending on your goals and concerns. For example, we usually advise our clients to direct their life insurance proceeds to trusts. But sometimes, even when people have trusts, they still want (or may be contractually obligated) to direct the life insurance proceeds directly to a person, instead of through that trust.

We say it a lot, but that’s because we mean it: there is no one-size-fits-all estate plan! And your estate plan includes your designated beneficiary instructions. So please take the following as advisory suggestions for you to discuss further with your attorney, not something you should implement without the guidance of experienced legal counsel.

If You Have No Estate Plan

Obviously, we do not recommend this option, but if you are just opening a policy and have not yet done your estate planning, you should at least designate a beneficiary and successor beneficiary of the policy. While this will get the money to the people you intend, be aware that doing it this way does not incorporate any marital deduction, tax apportionment, or other estate tax planning provisions. You should also be aware that if you designate a minor child as the secondary beneficiary of a life insurance policy, the courts will have to appoint a conservator to manage the funds for them, as children under the age of 18 cannot receive money directly. And then that child will receive whatever remains, no matter how much, and no matter how ready they are (or are not) to receive it (note: this is a terrible outcome that can and should be avoided with proper estate planning!)

You do have the option of naming a custodian as the successor beneficiary, and it’s likely that the courts will approve their appointment as conservator. Two important points about this option:

  1. The appointment of the custodian is not guaranteed. So keep in mind that if you do choose this option, you are taking the risk that your life insurance benefits will be held by someone who doesn’t have legal custody of your child. That could create a difficult situation for the guardian and the custodian, both.
  2. Appointing a custodian of the funds is not the same as setting up a trust and naming a trustee. Instead of being created by you, a custodian’s duties are defined under state statute in the Uniform Transfers to Minors Act, which can be read by following this link: CRS Title 15-14-104. Under the act, minors will receive any remaining funds, in full and outright, when they turn 21 (see our post on Is It Better Not to Inherit for some perspective on this).

Result: When you have no plan, you will typically name your spouse as the primary beneficiary and your descendants as the secondary beneficiary. If your descendants are minors, you may want to direct them to a custodian, with a specific note that the person would be holding the funds as conservator.

If You Have an Estate Plan

If you do have an estate plan, you will want to carefully coordinate your beneficiary designation instructions with your documents.

For a Revocable Living Trust

When you have a revocable living trust, the trust (via its trustee) is usually the first beneficiary. Directing the assets through the trust ensures that the trust provisions control how and when the money is distributed. Directing the money directly to people, even if they’re the same people as the trust beneficiaries, will bypass the provisions that you may have put so much thought and time into.

There are, however, situations where distributing directly to beneficiaries makes more sense, even when there is a trust in place.

Also, it often makes sense to list people as the secondary beneficiaries, just in case the trust is not in effect at the time of your death.

For an Irrevocable Trust

As with a revocable trust, when there’s an irrevocable trust, it frequently is the primary beneficiary of life insurance, with people listed as secondary beneficiaries, just in case the trust is defective in some manner that isn’t currently known.

For a Will

When you don’t have a trust, and your will does not create one, you will typically name your spouse as primary and your descendants as secondary beneficiary.

For a Will That Creates a Testamentary Trust

When you don’t have a trust, but your will does direct the creation of one after your death, you may again want to name your spouse first, but then the trustee named in your will as the secondary beneficiary.

Life Insurance Policies and Your Estate Plan

Coordinating the titling and beneficiary instructions attached to your financial assets with your estate plan is critical to your plan’s success. Ensuring that your life insurance policy and other bank accounts, investment accounts, and retirement assets are properly designated will allow the transfer of your assets to work the way your estate plan is designed. Our advice: Work closely with your attorney and financial planner to make sure this has been done properly. Review both your plan and your designated beneficiaries at least every year, so that if your life circumstances change (divorce/remarriage, adoption or birth, purchase of new house, starting a new job or business) your new situation remains in line with your plans for the future.

As with all complex fields, it’s best to have an expert in your corner. If you have questions about your estate plan or life insurance beneficiaries, come meet with us for an in-depth and personalized discussion about how you can best protect your assets during your lifetime and transfer them after your death.

Tienne McKenzie
Tienne McKenzie
tienne@themckenziefirm.com

Tienne is a paralegal specializing in estate planning.