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“Choosing a Life Insurance Beneficiary : The ‘Natural’ Choice Is Not Always Best”

By Matthew S. Dana

The blank on the life insurance application form simply reads “Beneficiary: _______.” Not a lot of room for what may be the single most important decision regarding your estate plan. Who should receive the insurance policy proceeds? The automatic response is: “My spouse, if living, otherwise, my then living children.” But this arrangement is often inadvisable for several reasons, and the alternatives demand consideration.

Spouse

You may not want your spouse to receive substantial life insurance proceeds outright for several reasons:

1. The proceeds become subject to the claims of your spouse’s current and future creditors.
2. The proceeds may become subject to rights and claims of your spouse’s next spouse, or the next spouse may use influence to deprive your spouse, or eventually your children, of the proceeds.
3. If the proceeds are paid directly to your spouse, they cannot fund a credit shelter trust to take advantage of the current $675,000 applicable exclusion amount. An over funded marital deduction often ultimately results in higher estate tax.
4. Children and other relatives may ask your spouse for gifts or loans or may offer bad investment advice.

Children

Naming your children or surviving children as beneficiaries is a lottery approach. You could be excluding a grandchild through a deceased child. Better to designate your ten-living issue or descendants per stirpes or by representation so that children of a deceased child will take the deceased child’s share. Also, many of the problems noted above for a spouse who receives substantial insurance proceeds outright also apply to outright payment of proceeds to children and grandchildren. Whether your children have the maturity to handle money may also be an issue.

Estate

Designating your estate as beneficiary will have the benefit of bringing all your assets together for effective credit shelter tax planning and for the use of spendthrift trusts.
But here are a few reasons why your estate should not be named:

1. The proceeds will become part of your probate estate and may be subject to creditors’ claims (though some state laws protect the proceeds from creditors.)
2. The proceeds will increase the size of the probate estate and may result in higher executor fees and attorney fees – especially when the fees are based in part on the size of the probate estate.
3. The proceeds may not qualify for the inheritance tax exemption provided by some states for insurance payable to a named beneficiary. In such states, a higher tax may be owed.
4. The proceeds may increase your federal and state taxes and perhaps state death tax as well.

Testamentary Trust

Naming a testamentary trust as beneficiary of an insurance policy may be appropriate, but the law in some states is not clear as to whether this approach will exclude the proceeds from your estate. Where permitted, it will facilitate use of credit shelter trust planning and spendthrift trusts. Of course, your will should specifically designate the trust or trusts to which the proceeds should be allocated, but this pre-designation will reduce funding flexibility.

Revocable Trust

Where the insurance proceeds are substantial (and you have determined not to try to remove the insurance from your estate for estate tax purposes,) you may name a revocable inter vivos (lifetime) trust as the beneficiary under the policy. The trust must exist before the designation is made and specify that the insurance proceeds cannot be used for certain estate obligations, such as creditor claims. Coordinate the trust with a pour-over will. This permits use of credit shelter trust planning and spendthrift trusts for your spouse and children.

Creditor

At times insurance is needed to secure a creditor, perhaps in connection with a business-related loan or a large mortgage. Although better ways to handle this situation may exist, often the creditor is named directly as policy beneficiary. Then you must specify clearly that the creditor is a beneficiary only to the extent of its interest (the debt obligation) and designate an additional beneficiary for any excess proceeds (or for all proceeds if the debt has been discharged.)

Noncitizen Spouse

Special concerns arise if your spouse is not a U.S. citizen. Insurance proceeds paid to a noncitizen spouse will not qualify for the estate tax marital deduction. A good solution is to designate as the beneficiary an inter vivos revocable trust or a testamentary trust under which a special qualified domestic trust (QDOT) is created to hold assets for the noncitizen spouse. A QDOT can qualify for the estate tax marital deduction. Alternatively, if you want your spouse to receive the proceeds outright, you may make a lifetime gift of the policy to the spouse and make him or her the owner. You are allowed to make annual gifts up to $103,000 per year to a noncitizen spouse. Your spouse would name himself or herself as the beneficiary of the policy.

Choose a Beneficiary Carefully

The designation of the beneficiary of your life insurance requires much more than passing consideration. Don’t just accept a suggested format that may accompany a policy application. Discuss your objectives and concerns with your professional advisors before you make this important decision.

Have You Properly Funded Your Revocable Living Trust?

If a revocable trust (living trust) arrangement is the keystone of your estate plan, consider whether you have taken the necessary steps to implement all of the trust’s attendant advantages. To enable your trustees to administer the living trust effectively if you become incapacitated, it should own your assets. This will also help avoid subjecting your assets to probate transfer proceedings when you die.

Transferring Assets To Your Living Trust

You may accomplish the transfer of your assets to your living trust with the assistance of an estate planning professional or other advisor, or you may do it yourself. In general, transferring bank accounts, certificates of deposit, brokerage accounts, mutual fund accounts and securities may require only a specific letter of direction and a certification of certain trust provisions. The transfer of the following assets to your trust requires additional documentation:

Tangible personal property – titled. To transfer automobiles, boats, airplanes and other items of personal property that require title registration, you need to obtain the necessary official documents to assign your interest to the living trust and pay the required fees. For example, you’ll need to contact the Secretary of State to obtain the proper form to transfer your automobile title to the trust. Be sure to verify that your liability and property insurance coverage extends to the trust.

Tangible personal property – untitled. As with cash, the difficulty with transferring untitled tangible personal property is establishing that the living trust owns these items and they’re not probate assets. Attach a general assignment of the tangible personal property – stating that assets are being transferred or assigned to the trust – to a specific listing (or photographs or videotape) of the items the assignment covers. With respect to works of art and larger antiques, you may also want to attach a label to the items identifying the living trust as the owner. In all events, your insurance policy should reflect that the trust owns these items and you should extend your coverage.

Real property. The first step in transferring real estate to the living trust is to prepare and record a property deed that conveys title to the trust. Whether a warranty, special warranty deed or quitclaim deed is better depends on the circumstances. In addition, confirm that your title insurance policy extends to the trust. You may need to obtain a policy rider extending coverage for a new policy. Check property and casualty insurance policies to ensure that coverage continues; otherwise, obtain a new policy or policy rider. With respect to leased property, notify the lessee to pay rent to the trust in the future.

Limited liability company (LLC) and partnership interests. Review each LLC and partnership agreement to determine whether a transfer to your living trust is permitted and you’ve met the transfer requirements. Then prepare general assignments and consents and obtain the requisite signatures from those who must consent to the transfer. Determine whether you need to amend assumed name certificates, limited partnership certificates or LLC filings. In situations where the LLC or partnership interest has little or no value and transfer is difficult because of extensive requirements, continuing to hold these interests individually may be better than transferring them to the living trust.

Proprietorship.Generally, an assignment or bill of sale of a proprietorship to the living trust – including all assets, names and other items of goodwill – will be sufficient. Determine whether the trust can own a proprietorship. If not, consider forming a partnership making your spouse a 1% or greater partner or forming a single – member LLC and then transferring interest to your living trust.

Life Insurance. Typically, if life insurance is payable to a named beneficiary, the insurance proceeds will not be subject to probate procedures. But if your intent is to change beneficiary designations in the future and you become incapacitated before doing so, you’ll have to make these changes under a guardianship or durable power of attorney arrangement. Accordingly, transfer life insurance ownership to your living trust so that a successor trustee may deal with the policies should you become incapacitated. You can obtain change of ownership forms from your insurance company. Also, if the insurance is currently payable to your estate, designate your living trust as the beneficiary.

Qualified benefit plan and individual retirement plan accounts. Payments of retirement plan account benefits requires special consideration and should be reviewed separately. Potential issues relate to the ability to change a designated beneficiary, naming the living trust as beneficiary, qualifying for the marital deduction and dealing with distributions from the plan during your lifetime should you become incapacitated.

Prepare for Success

Setting up a living trust and properly transferring your assets to it may seem complicated however; the benefits of avoiding probate are well worth the effort. Remember to keep copies of what you mail to the rust, follow up after a reasonable time and ask for help when needed. We are here to answer your questions and assist you every step of the way in achieving your estate planning goals.