How to choose a life insurance beneficiary

 

Buying life insurance is a unique part of a creating your financial plan because you don’t buy life insurance for yourself. You buy it to provide financial security for those you love. But, strangely, many people don’t spend much time naming the people who should get the money after they die. In fact, thousands of people die every year with outdated or incomplete policies.

Imagine this. Your spouse passes away, and only then you discover that his or her former spouse is named as the beneficiary for the policy. Awkward. Unfortunately, these situations happen all the time. People forget to indicate who they want to receive the pay out of their life insurance policy, or they do name someone and never go back to update if they have a child, get married or even get divorced.  And just like that, a grieving family is dealing with a huge legal mess at an already stressful time.

No one wants that. You may be wondering by now, what even is a beneficiary and how do I pick one? Don’t worry -- you aren’t alone. It’s confusing, so we’ve answered some of the most common questions people ask about life insurance beneficiaries.

What does “life insurance beneficiary” mean?

Great question. Glad you asked. To start, a beneficiary is a person who gains an advantage and/or profits from something else. So when it comes to life insurance, it’s basically the person or legal entity named in a life insurance policy entitled to receive the money from the policy upon your death.

What do you mean by person or legal entity?

Another great question. Most often, policyholders name individuals to receive the money. If you’re married, that’s usually your spouse. You can also select  your children and/or parents. But it doesn’t always have to be a person. You could name your estate, or a trust, even a charity.

So can anyone be my beneficiary? Can I name my BFF?

No. Naming beneficiaries on life insurance is serious. You can’t name your dog. Or a friend. To qualify as a beneficiary, there must be an “insurable interest” between the policyholder and the beneficiary. That means the beneficiary would suffer financially if you died. Like your children. And since there would be no economic loss to a friend, that person no insurable interest. In fact, the insurance company could deny the policy.

Okay, so who can I name as my beneficiary?

Only you know the reasons you bought life insurance in the first place. Ideally, you’d name the people you want to protect financially, such as:

Spouse. This is the most common beneficiary. Even if both spouses work, there would still be a significant loss of income to the surviving spouse. 

Domestic partner. While many laws protect a spouse’s interests, things can get complicated for domestic partners. Be sure to name him or her in the policy.

Former spouse. If you divorce, but don’t remarry, you may still want to provide for a former spouse, especially if you have children together.

Children. Having children is the single biggest reason people buy life insurance but be careful. Naming children under the age of 18 could create legal issues…keep reading for details on this!

Parents. If you’re single, you might name your parents, so they can use some of the money to pay your funeral expenses. Or they may have cosigned your student loans, in which case they can use the money to pay back the loan. Or they may be older and depend on you financially.

Sibling. As with naming a parent, you could designate a sibling to receive the money and pay your funeral expenses.

Business partner. If you own part of a business, you may consider naming your partner, so the company can continue without you.

Charities. If your family is financially secure, you might name a charity as your beneficiary, so the organization can continue doing the work you believe in.

Bank. Yes, a bank. Banks sometimes require life insurance policies as collateral. You’d name the bank as primary beneficiary for the balance of the loan, and a secondary beneficiary to receive the remaining death benefit.

Your estate. You could designate your estate to receive your death benefit. To do this, you must have a will, with the money going to your Executor. There are legal issues to consider when you name your estate, which we will get into later.

A trust. If you have small children, you could set up a trust to manage their finances until they’re of legal age. The money would go to the trust, while a trust manager would pay for your children’s needs according to your instructions.

What if I can’t choose one beneficiary? Can I have more than one?

Of course. With life insurance, multiple beneficiaries are just fine. But each one must have an insurable interest. Naming multiple beneficiaries also means deciding who is the primary beneficiary, and who is the contingent (or secondary) beneficiary. There’s a reason for this.

Let’s say you have two children and your spouse is your sole beneficiary. Suppose you and your spouse die at the same time. Who gets the money? That’s where a contingent beneficiary comes in. You might name your spouse as the primary beneficiary and your sister as contingent beneficiary, assuming she’d care for your children after you die.

What information should I include about my beneficiaries?

Simple. As much as possible. Designating "spouse" or "children" causes a legal mess if you get divorced and remarried. Use the beneficiary’s full name, address, phone number, date of birth, and relationship to you. If you have their Social Security number, even better. And, of course, the percentage of the death benefit he or she should receive.

You mentioned different kinds of beneficiaries? What are they?

Life insurance companies define two beneficiaries – primary and contingent beneficiaries. Some may define a third, tertiary. Each has different legal rights:

Primary beneficiary. First to receive money from a policy. But, if the beneficiary of the life insurance policy is deceased, the beneficiary receives no money.

Contingent beneficiary. Also known as a secondary beneficiary, this individual only receives money if the primary beneficiary is deceased.

Tertiary beneficiary.  This beneficiary receives money only if the primary and contingent beneficiaries are dead. Only a handful of life insurance companies include tertiary beneficiaries on their policies, but it’s still important to know.

How do beneficiaries split the money?

That, my friend, is up to you. If you’ve named multiple beneficiaries, you need to divide the money. You can either designate a dollar amount, or a percentage. Generally, it’s best to state a percentage, say 50% to your spouse and the remaining 50% to your children. This makes it easier in case the value of the policy has grown larger than the death benefit.

What mistakes should I watch out for?

Life insurance is a legal contract, so details matter. Otherwise, you risk a legal tangle that might take years to unravel. Here are mistakes that can cause big headaches:

Designating minor children. Naming underage children creates all sorts of legal issues. Insurance companies won’t distribute money to children under 18 or 21 (depending on the state). The insurance company will require you to name a legal guardian. If you don’t, the court will name one and place the money into a trust managed by the guardian. And that may not be what you had in mind.

Designating your estate. You must draw up a will and not name a beneficiary. The death benefit would then go to the Executor of your estate. This must also be approved by a probate court, which could eat up some of your estate’s assets in attorney fees, CPAs, and appraisals. Creditors can also make claims against the estate, something they can’t do if your heirs are paid directly.

Forgetting to tell your beneficiaries. Yes, this happens. Be sure to let your beneficiaries know. Also provide contact information for the insurance company.

Incorrect or outdated beneficiaries. Misspelling a name, getting an address wrong, listing a former spouse, these can all lead to legal problems. Check and double check the information you provide to your insurance company.

Is that it? Once I’ve named a beneficiary, I’m done?

You can never forget about your beneficiaries. People die, move away, get remarried, divorced, have children, etc. Anytime you experience a major life event, you need to review your policy and beneficiaries. Make sure the people you’ve named are still alive, at the address noted in your policy. Make sure you still need to financially protect your beneficiaries, and an insurable interest still exists. Remember, you’re not locked in to your beneficiary designations forever. You can change them as often as you’d like throughout the life of your policy.

If you follow these guidelines for naming beneficiaries on life insurance, you can rest assured the people you had in mind when you bought your policy will be protected the way you intended.