Life insurance death benefits are a major consideration in the area of estate planning. Life insurance is a source of financial support that is intended to pay for college, death and estate taxes, funeral expenses, payments towards one’s house, and other goals. Typically, there are two (2) types of life insurance plans: term life insurance and whole life insurance:
Whole life insurance plans involve a cash-value account which increases in value over time like a savings account. This type of plan allows for the insured to build cash value. Additionally, these policies are an excellent asset protection tool for professionals, because whole life insurance policies are exempt from creditor’s claims in the state of Illinois. Whole life insurance plans also provide payment of dividends and allow loans against the cash value accumulation.
Term life insurance is temporary life insurance which covers a person for a specific period of time and provides a death benefit upon the insured’s death, so long as the death occurs during that period of time. Unlike whole life insurance, term life insurance does not provide guaranteed cash value accumulation, nor does it earn dividends from the life insurance company.
In both types of plans, the insured person names one or more beneficiaries who will receive the life insurance benefits upon the insured’s death. A primary beneficiary is the insured’s first choice for receiving life insurance proceeds. A contingent beneficiary is the second choice; multiple contingent beneficiaries can also be named. If the primary beneficiary or contingent beneficiary(ies) die before the life insurance owner, then the life insurance proceeds will go to the next designated beneficiary in the order of priority established by the insured. It is important to appoint primary and contingent beneficiaries because individual beneficiaries may be deceased or have developed special medical issues by the time the insured dies. In choosing beneficiaries of one’s life insurance policy, we recommend considering designating as beneficiary a revocable living trust. A revocable living trust is an alternative to a last will and testament which can be named as a beneficiary of one’s life insurance proceeds. There are multiple benefits to a revocable living trust. For more information, please see our blog post titled Estate Planning.
One of the components of estate planning is setting forth a game plan for how life insurance death benefits should be paid. Often, the primary or contingent beneficiary(ies) predecease the life insurance owner, creating ambiguity and potential conflict. When life insurance death proceeds lack a contingent beneficiary, a probate proceeding may be necessary to determine who should receive the death benefits.
Life insurance mistakes, such as the failure to properly designate beneficiaries who can inherit, are costly and designating beneficiaries can lead to heart break and family chaos. There are six common mistakes those naming beneficiaries for their life insurance policy make:
1. Naming a beneficiary who is eligible for government benefits
The first mistake is naming a child or disabled adult who is eligible for government benefits such as Medicaid or social security disability. Naming a child with special need child as the beneficiary of a life insurance policy has unintended consequences. For instance, the beneficiary’s eligibility for government benefits may be jeopardized. Government assistance programs have a $2,000 in assets threshold, meaning that disabled adults who receive a gift or inheritance greater than $2,000 may be disqualified from Supplemental Security Income and Medicaid under federal law.
Medicaid is a federal program administered by the states, including the state of Illinois. Medicaid also provides health insurance benefits for minor children when their parent or guardian cannot afford to provide health insurance themselves. The disabled person or recipient of Medicaid must be eligible to qualify for this federal program. In determining whether an individual qualifies, there are exempt and non-exempt assets. Assets such as a home where one resides are exempt assets in the state of Illinois. Working with a qualified estate planning attorney is beneficial because we understand the complex rules and regulations surrounding this issue, and can work to achieve the optimum result through the creation of different types of trusts.
One type of trust that can assist with this is a third-party special needs trust. This type of trust, otherwise known as a supplemental needs trust, is a way to leave a gift or inheritance to a disabled person while ensuring the remain eligible for government benefits. A supplemental needs trust supplements government benefits, such as Medicaid, rather than resulting in disqualification of those government benefits. In other words, supplemental needs trusts guard gifts and inheritances that a special needs’ person receives and protects from disqualification of governmental benefits programs. Generally, this type of trust allows for expenditures that the government program does not authorize, such as the purchase of a car or a condominium for a disabled adult. Unlike naming individual beneficiaries, the idea behind a special needs trust is to provide a flexible plan to serve the needs of a special needs’ adult and maximize asset protection of their assets.
2. Naming a minor child as beneficiary
The second mistake is naming a minor child or children as the beneficiary of a life insurance policy. This is a mistake because minor children cannot inherit life insurance benefits in the state of Illinois (and in most states). For this reason, life insurance providers such as Met Life and Northwestern Mutual will not pay insurance death benefits directly to minors. Oftentimes, spouses name each other as primary beneficiaries and their minor children as contingent beneficiaries. However, in doing so, they do not factor in the possibility that they may die while their children are still minors, or that they may die at the same or close to the same time, such as in a car accident. Alternatively, single parents sometimes designate their minor child as their primary beneficiary without understanding the financial consequences.
Minor children inheriting assets such as life insurance will force families to undergo guardianship proceedings, which can cause conflict and can be expensive. A guardianship procedure is a type of probate court proceeding which requires a lawyer and yearly accounting of assets. Additionally, families sometimes fail to designate responsible guardians for their children, which creates additional problems. For more information on the role of a guardian, please see our blog post entitled Guardianship of a Minor.
Even if the child is no longer a minor but is still a young adult at the time of the insured’s death, other problems might result. For instance, the young adult may not have the maturity necessary to handle a receiving large inheritance without restrictions. The immaturity of young adults ranging in age from 18 to 25 years old can be a recipe for trouble. An inexperienced adult child may lack the financial understanding to make payments that life insurance benefits are often used to make, such as mortgage or house payments, and taxes.
A related issue that it is important to consider when designated life insurance beneficiaries is the possibility of additional children born or adopted after the life insurance beneficiaries are designated. A well-thought estate plan can automatically provide for newly born or adopted children. This is crucial, as many parents fail to update their life insurance and wills in a timely manner.
3. Failing to update the primary beneficiary after an important life event
The third mistake is the failure to update the primary beneficiary designation after an important event. For example, if the primary beneficiary designation is made, and a subsequent divorce happens, the failure to update your life insurance policy can lead to unintended consequences. Owners of insurance policies should update their policies upon major life events such as divorce, marriage, having a child or children, and/or a disability of one beneficiaries. Failure to update policies, especially if you have a blended family or step children, can cause major issues. Blended families have natural conflicts, and estate-related conflicts and litigation can be time consuming and expensive. In addition to updating your life insurance policy, it is important to update your last wills and trusts upon any significant event. Like with your insurance policy, failure to do so can cause significant problems.
4. Failing to name contingent beneficiaries
The fourth mistake is naming only a primary beneficiary. This is a major mistake because it creates the possibility of significant probate issues. Probate is the court which decides where an inheritance should go if the deceased does not do so through estate planning. Intestate succession is the law in the state of Illinois which determines how an asset should be distributed when a person dies with no will or legal plan in place. Ideally, many people use estate planning to avoid probate court because of the issues it can cause, such as the magnification of problematic family relationships and the involvement of “long-lost” family members. Unfortunately, money and assets can bring out bitterness and unforeseen consequences when in probate court. Hiring a qualified estate planning attorney to assist couples and individuals plan often avoids estate litigation and disputes, as well as the resultant family conflicts.
One reason that it is important to hire an experienced estate planning attorney is that they are able to consider key details and potential family conflicts when drafting your estate plan. Failure to consider these factors is a major mistake that can cause family disharmony and hundreds of thousands of dollars in attorney’s fees and costs. In addition, our attorneys help the client understand and consider circumstances that they might otherwise neglect to account for. For instance, many spouses fail to consider that it is possible that they may die before their spouse or beneficiary. Relatedly, many people do not anticipate and plan for the death of one beneficiary when multiple are named. In this circumstance, it is important to dictate how the deceased beneficiary’s inheritance should be handled: should the surviving beneficiaries split the inheritance equally or should the deceased person’s children or branch of their family receive the deceased beneficiary’s share?
5. Failure to plan for familial conflict when naming beneficiaries
The fifth mistake is the failure to plan for natural conflicts in the family. Many families have one adult child that resides with their parents. A natural conflict exists between adult children that are independent and an adult child that resides with their adult parents. An experienced estate planning attorney understands that this conflict may occur and can develop an appropriate plan. For example, a living trust can provide life insurance for the adult children that live elsewhere and provide the home to an adult that resides with his or her parents. This reduces the likelihood of a family dispute and creates a realistic plan to address a complex problem. Another example is the challenge created by leaving a house to five children and expecting those children to figure out how to split the gift. A living trust can provide a plan for the children to work together. Furthermore, a living trust designates a successor trustee that is responsible for spearheading the wishes of the creator of the living trust, which can be helpful if issues do arise.
6. Failure to plan for estate taxes
The sixth mistake is the failure to plan for estate taxes, especially estate taxation in the state of Illinois. Illinois has its own estate tax, which applies to a deceased person’s estate if the value is more than $4 million. The federal estate tax exemption was $11.2 million in 2018. There are several strategies that we can employ in order to best address the issue of estate taxes.
Families often fail to consider that life insurance proceeds are a major asset.
One tool that can be utilized in this area is a credit shelter trust, also known as an “A/B” Trust. A credit shelter trust is a type of trust which enables a surviving spouse to maximize their estate tax exemption by automatically using their state and federal tax exemption. This type of trust utilizes each spouse’s state and federal tax exemption limits to protect one’s assets against estate and gift taxation.
Another planning strategy is called an Irrevocable Life Insurance Trust, otherwise known as an “ILIT”. There are several parties involved in an ILIT. The first is the individual who creates the ILIT, who is the grantor, otherwise referred to as the “maker”. The second person is the trustee. The trustee (or co-trustees) are chosen by the grantor, and are responsible for managing the life insurance proceeds. Finally, an ILIT requires one or multiple beneficiaries, who are the individuals who receive the benefit of the ILIT. An ILIT involves a person’s (the maker’s) life insurance proceeds being transferred to their trust with the maker as the insured and the beneficiaries of the ILIT as the beneficiaries. The life insurance proceeds may pay for estate and administrative expenses upon the maker’s death, including attorney’s fees, debts, probate costs, and income taxes.
An important feature of an ILIT is that it is irrevocable. This means that the grantor cannot revoke, alter or amend their trust, with certain limitations. Another important aspect of an ILIT is the asset protection and estate taxation minimization, which are major benefits of this kind of trust. Many people are concerned with protecting their assets from being inherited by their in-laws. This type of trust helps ensure that this situation does not occur. Other people are concerned with their beneficiary’s potential liabilities, such as business lawsuits, divorce proceedings, child custody conflicts, and foreclosure lawsuits and other creditor concerns. Parents can combine a ILIT with a bloodline trust in order to keep a family’s assets and trust assets in the blood families name. This also avoids in-laws re-directing a parent’s hard-earned assets to their family members.
Sean Robertson is a graduate of DePaul University College of Law and University of Illinois at Urbana-Champaign. Sean is the principal of Gateville Law Firm.