A common misconception people have about life insurance is that they only need to designate their spouse, child, or loved one as the beneficiary of the policy to ensure that the life insurance benefits will be available to the beneficiary when they die. Life insurance is an important financial and estate planning tool, but without certain protections in place, there is no guarantee that your beneficiary will receive, or keep, the benefit from your insurance. Consider these two examples:
Example 1
David identified his wife, Betsy, as the beneficiary of his life insurance policy. At David’s death, Betsy does receive the death benefit from the insurance policy, but when Betsy remarries, she adds her new husband’s name as a joint owner of the bank account where she deposited the death benefit. In so doing, she inadvertently leaves the entire death benefit from David’s life insurance to her new husband instead of to the children she and David shared, as they had discussed before his death and as indicated in her will.
Example 2
Dawn, a single mother, named her ten-year-old son Mark as a beneficiary of her life insurance. She passes away when he is twelve. The court names a relative as a guardian for Mark until he is legally an adult. By the time Mark reaches his eighteenth birthday, his inheritance has been partially spent on court costs, attorney’s fees, and guardian’s fees. Dawn had hoped that the life insurance proceeds would be available to pay for Mark’s college, but because of the costs, there is less money available to Mark. He receives the remaining funds, spends them frivolously, and within a year or two has nothing left.
To avoid these situations, a common method for leaving money and property to loved ones in an estate plan is by making a trust the beneficiary of the life insurance policy, with a spouse or child as the trust’s beneficiaries. One popular ways to achieve this result is by setting up an irrevocable life insurance trust.
You can create an irrevocable life insurance trust either by transferring ownership of an existing policy into the trust or by the trust purchasing a new policy. Using your annual gift tax exclusion, you make cash gifts to the trust to pay the insurance premiums. Upon your death, the trust receives the death benefit and the trustee distributes the money according to the instructions in the trust document.
This strategy also allows you to remove the value of the life insurance policy and the death benefit from your taxable estate.