Is Trouble Lurking in Your Clients’ Life Insurance Coverage?

Ownership & Beneficiary Mistakes Your Clients Should Avoid

Life insurance is one of your clients’ most important financial assets. A properly structured policy and the resulting death benefit can help support a surviving spouse, pay for a child’s support and education needs, provide liquidity to help the family meet estate tax obligations, or ensure the continuation of a business. Whatever the purpose of a client’s life insurance coverage, properly structuring the ownership and beneficiary of a policy is essential to make certain the policy meets its intended purpose.  Unfortunately, clients are often unaware of the unintended consequences associated with an improperly structured policy, and advisors should be prepared to help them avoid five frequent mistakes.

Mistake #1 – Naming Minors as Beneficiaries

Life insurance is frequently used to protect the lifestyle of a surviving family should an income-earning parent prematurely pass away. The life insurance death benefit replaces the lost income of the deceased parent, and provides for the medical, education and general support needs of the minor children. As the life insurance death benefit is intended to benefit the children, parents often name them as the direct primary or contingent beneficiary of the policy. Yet, minor children cannot legally own assets an any state until they reach the age of majority. 

Naming a minor child as the beneficiary of a life insurance policy essentially guarantees the probate court’s involvement. Because the child cannot legally own assets, a guardianship or conservatorship (a financial guardianship) will be required, and the court will oversee the investment and expenditure of the funds on behalf of the child. This court involvement is usually quite costly and requires those acting on behalf of the minor child to jump through additional administrative hoops to be able to access the funds for the child’s needs.  Moreover, once the child reaches the age of majority (18 or 21 years old), the remaining funds are ordinarily distributed directly to the child. Most 18 or 21 year olds are not financially savvy enough to handle a large sum of money, and their inherited funds are likely to be squandered.

A more efficient method of leaving a life insurance death benefit to a minor (or young adult) child is through a trust. A properly structured testamentary trust, contained within a will or revocable trust, will provide for the child’s needs per the terms of the trust. The child can receive outright access to the funds at an age at which they are more likely to be more financially mature, thus reducing the chance of misusing the funds. 

For clients who have not included a testamentary trust in their estate planning documents, the Uniform Transfers to Minors Act (UTMA) serves as a less-then-optimal solution, though better than naming the minor child outright. UTMA allows a client to appoint a custodian on behalf of the minor child in the beneficiary designation. Upon the parent’s death, the custodian can take control of the insurance death benefit in their fiduciary capacity as custodian and hold the funds on the child’s behalf until they reach the age of majority. Until that time, the custodian can generally make expenditures to take care of the child’s needs. This arrangement generally eliminates the need for the probate court’s involvement.

Mistake #2 – Designating the Estate as Beneficiary

When a life insurance policy owner is not certain who the appropriate beneficiary of the life insurance policy should be, they frequently name their estate as the primary beneficiary. Naming the estate as beneficiary generally requires the death benefit to pass to estate beneficiaries through the probate process, which can result in:

• Unintended beneficiaries receiving the insurance proceeds;
• Delayed distribution of insurance proceeds to heirs;
• Insurance proceeds becoming subject to creditors’ claims;
• Increased probate expenses; and
• Court supervision of the insurance proceeds for minor beneficiaries.

Instead of naming the estate as the policy beneficiary, the beneficiary designation should be consistent with the intended purpose of the coverage. If the insurance is intended to benefit the spouse and minor children, then it may be most appropriate to list the spouse as the primary beneficiary and a trust for the benefit of the minor children (or a custodian under UTMA) as the contingent beneficiary. Listing individuals as policy beneficiaries (or trusts on their behalf) is generally always preferable over naming the estate as the policy beneficiary.

Mistake #3 – Designating a Bank/Lender as Beneficiary

Banks and other third-party lenders frequently require borrowers to purchase a life insurance policy naming the lender as beneficiary as a way of securing repayment of a loan. However, upon the death of the insured, if the death benefit paid exceeds the outstanding balance of the loan, the lender could collect a significantly higher payment than it was entitled to. 

Rather than naming the lender as the primary beneficiary of the policy, a collateral assignment allows the borrower to assign to the lender, from the life insurance death benefit, the exact amount owed under the loan as of the insured’s date of death. Any excess death benefit would be paid to the insured’s primary beneficiary named on the policy. This collateral assignment ensures the lender will not receive a windfall from the life insurance death benefit.

Mistake #4 – The “Unholy Trinity”

The life insurance “Unholy Trinity”, also known as the “Goodman Rule”, refers to the three separate parties of a life insurance policy, the (1) owner, (2) insured and (3) beneficiary. When each party is a different person or entity, the insurance death benefit generally becomes taxable. As an example, assume Wife is the owner of a life insurance policy insuring Husband’s life, with Children as the policy beneficiaries. Upon Husband’s death, the payment of the death benefit to Children is treated as a taxable gift from the policy owner, Wife, to the policy beneficiaries, Children.

Further consider another example frequently encountered with business owned life insurance. Assume Business owns a life insurance policy on the life of Employee, and Employee’s Spouse is the policy beneficiary. Upon Employee’s death, the payment of the death benefit will generally be considered taxable income from the policy owner, Business, to the policy beneficiary, Employee’s Spouse.

Avoiding an “Unholy Trinity” situation can be accomplished by a two-part rule. First, if the insured is also the policy owner, no “Unholy Trinity” exists. Second, if the insured is not the policy owner, then the policy owner should also be named as the policy beneficiary. 

Mistake #5 – Individual Policy Ownership

Life insurance policies are most frequently owned by an individual policy owner. However, most clients are not aware that life insurance death benefits are included in their taxable estate for federal estate tax purposes. While federal estate tax exemptions are at their highest historic level resulting in very few estates being subject to the tax, the current exemption is scheduled to be cut in half effective January 1, 2026. This exemption reduction will result in a significant increase in the number of estate subject to the tax. 

Clients whose estates are currently or may in the future be subject to federal estate taxation should consider third party ownership of their life insurance coverage. This third-party ownership usually occurs in the form of an irrevocable trust. When an irrevocable trust is the owner and beneficiary of a client’s life insurance policy, it is kept outside of the taxable estate and will not be subject to federal estate taxation. 

Third-party ownership of life insurance coverage with an irrevocable trust also provides additional benefits, including asset protection of the policy proceeds from potential creditors of the trust beneficiaries, as well as protection from a potential spendthrift beneficiary. 

If your client personally owns their life insurance coverage and wishes to remove it from the taxable estate, they should proceed with caution. A change of policy ownership to an irrevocable trust is considered a gift of the policy. Accordingly, it is essential for your client to understand the full tax ramifications of any such transfer. Additionally, the life insurance “Three Year Rule” requires the insured to outlive the transfer to the trust by at least three years. If the insured dies within three years of the transfer, the death benefit is included in the taxable estate.

Summary

Life insurance policies are an important part of your clients’ financial security. While most clients understand the need for life insurance, mistakes in the policy ownership and beneficiary designations can lead to a policy’s failure to meet its intended objective, or at minimum, do so in a more inefficient manner. Guiding clients on the most appropriate and efficient policy structure for new insurance policies is essential, as is reviewing the ownership and beneficiary structure of your clients’ existing policies.