A life insurance beneficiary is the person, group, or organization you elect to receive the proceeds of your life insurance policy if you pass away.
Because of the potential financial, legal, and tax consequences related to choosing a beneficiary, it’s important to understand the various types of beneficiaries you can select and how the process works.
Choosing your beneficiaries carefully can help you avoid making simple yet costly mistakes and ensure your family’s protection.
What Are the Types of Life Insurance Beneficiaries?
As much as we try to prepare for the ups and downs of life, it often comes with unexpected changes.
The person you name as your life insurance beneficiary could pass away before you, or your family or business relationships might change over time.
For this reason, the best life insurance companies provide flexible options for designating beneficiaries.
Primary vs Contingent Beneficiaries
With the designations below, you can choose primary and backup beneficiaries for your policy.
- Primary beneficiary: The primary beneficiary is the individual(s) or legal entity you chose to receive the death benefit first. If the beneficiary is alive and available at your death, he or she will collect the policy proceeds.
- Contingent beneficiary: The contingent beneficiary, also known as the secondary beneficiary, is the next in line to receive the policy proceeds. The contingent beneficiary collects no payout if the primary is still alive when you die. Like the primary designation, there can be more than one contingent.
- Tertiary Beneficiary: Last, you can opt for a third-tier beneficiary who will receive the policy proceeds if both the primary and secondary beneficiaries are deceased or otherwise unavailable.
Revocable vs Irrevocable Beneficiaries
Life insurance beneficiaries can be broken down further into two special classes – revocable and irrevocable.
- Revocable beneficiaries: In this case, you have the right and ability to change the beneficiary to your policy without your previous beneficiary’s consent.
- Irrevocable Beneficiaries: If you’ve named an irrevocable beneficiary, you may not change the designation without the consent of the previous beneficiary.
Most life insurance experts recommend you only use the revocable option to avoid legal issues in the future.
Who Should You Choose as a Life Insurance Beneficiary?
You can choose an individual as your life insurance beneficiary, or a legal entity such as a business, charity or trust.
Depending on where you live and who you have in mind, designating a beneficiary may not be as simple as filling out a form with their information.
Immediate family members who are financially dependent on you should top your list of potential beneficiaries. One of the key individuals fitting that description is your spouse.
Leaving your policy to your partner can also ensure your children’s future wellbeing. This is the simplest beneficiary designation you can opt for and comes with no real hurdles.
Another popular option, especially for single parents, is leaving the proceeds of a policy to children or step-children.
Just note that designating a minor as your life insurance beneficiary will come with some hurdles. Until the child reaches the age of majority, the policy’s benefits will be placed in a trust for safekeeping.
The death benefit will either be entrusted with the child’s legally-appointed guardian or the policyholder’s chosen fiduciary.
Other Family or Friends
Beyond the individuals above, you can designate a domestic partner, parents, siblings, or any other member of the family or friend to receive the policy’s proceeds.
If you live in one of the states below and take out life insurance and wish to designate anyone other than your spouse as a beneficiary, you are obligated to obtain legal consent from your spouse:
- New Mexico
Note that these restrictions, known as community property laws, only apply to policies taken out after your marriage begins.
The proceeds from a life insurance policy can also be left to your estate. The death benefit amount will be paid to the Executor or Administrator of the estate.
That individual can use the policy’s proceeds as he or she sees fit, usually to pay for estate taxes or provide financial assistance to dependents.
However, your estate’s Executor or Administrator must also be named in your last will and testament and approved by the probate court.
Life insurance trusts are legal entities used for estate planning purposes, and they can be designated as the beneficiary of your policy.
Depending on the type of trust that is set up, the proceeds from the policy may or may not even be included in your taxable estate.
If the proceeds are not included, you could potentially save your loved ones a great deal in estate taxes.
Charity or Business
You may also choose to designate a charity, organization, or business as your life insurance beneficiary.
Naming a charity as either the primary or secondary beneficiary is an excellent way to donate to a cause you care about, as long as your loved ones are protected.
On another note, when businesses or partnerships purchase key person life insurance, the business itself becomes the beneficiary of the policy.
How Do You Name Multiple Beneficiaries?
Because the death benefit may increase or decrease due to investment gains, earned interest, fees, etc., using percentages rather than dollar amounts can help prevent a potential legal battle over payout amounts.
There are two approaches to choosing multiple beneficiaries– per stirpes and per capita.
An estate is distributed per stirpes if each branch of a family receives an equal share. When using per stirpes, you can designate the beneficiaries via your family line.
Example: You assign your son (Aiden) and daughter (Sophia) as equal beneficiaries. Unfortunately, your son dies before you do. If you passed away, Sophia would receive 50% of the death benefit while the remaining 50% would be evenly distributed to Aiden’s surviving children.
Alternately, with the per capita method, the policy’s proceeds will be distributed equally among all of the survivors.
Example: Returning to the scenario above, suppose Aiden had 3 children. The policy proceeds would be divided evenly between Aiden’s 3 children and Sophia, with each individual receiving 25% of the total payout.
How Do You Change Your Life Insurance Beneficiary?
Life changes such as marriage, divorce, death, the birth of a child, or a change in your business, can require an amendment to the beneficiary on your policy.
Some companies allow you to change beneficiaries online, while others require you to verify your updates over the phone or submit paperwork in the mail.
You will need to contact your life insurance company to see their requirements.
What If You Don’t Name a Life Insurance Beneficiary?
When you fail to select a life insurance beneficiary altogether, all of your policy’s proceeds will be paid to your estate. In this instance, the distribution of your policy will be the court’s decision rather than your own.
This legal process, known as probate, complicates the allocation of your death benefit and takes more time. Since your policy is added to your estate, it may also require your loved ones to pay taxes.
Do Beneficiaries Have to Pay Taxes for Life Insurance?
It depends. In most cases, the benefits paid out to life insurance beneficiaries are tax-free, but there are a few exceptions.
In the scenario above, where no beneficiaries are designated, your loved ones may be responsible for paying estate taxes once they receive the funds from the policy.
The other reason beneficiaries might be responsible for taxes is interest. If your beneficiaries don’t claim the full amount of the policy immediately, they might have to pay taxes on interest.
In terms of taxable income, your beneficiaries do not have to include the benefit of your life insurance policy on their tax return.
How Do Life Insurance Beneficiaries Get Paid?
To receive the benefit of a life insurance policy, the beneficiary simply contacts the provider, fills out the necessary paperwork, and submits any documentation requested.
In terms of the distribution of benefits, beneficiaries usually have two options.
- Installments: If they wish, your beneficiaries can opt for incremental payments. Some people find monthly or annual payments to be more manageable and less risky. Just note the potential tax implications of accruing interest.
- Lump-sum payment: As its name suggests, a lump sum payment gives beneficiaries the full amount of the death benefit in one payment. This option is the most advantageous for tax purposes and can help cover final expenses.
Can Beneficiaries Be Denied Access to Life Insurance Benefits?
In most cases, filing a claim and receiving the death benefit of a life insurance policy is smooth sailing for beneficiaries; however, there are a few instances that can lead to a denial.
If you die of a medical condition you failed to disclose in your application, the life insurance provider may legally refuse to pay out your policy.
They can also terminate the policy agreement if you die of disease related to a habit you failed to share, like smoking that led to lung cancer.
Likewise, if you left a risky hobby out of your application and die in the act, your loved ones may be denied the death benefit or could receive an adjusted death benefit that takes the elevated cost of high-risk coverage into account.
With the above in mind, it is crucial to be honest in your life insurance application. The dollars you save in premiums are not worth the risk of leaving your loved ones unprotected one day.
If you commit suicide within two years of taking out your life insurance policy, the company might not pay out the benefits to your beneficiaries.
Most life insurance policies come with a suicide clause stating the company’s rules for cases involving suicide. In many instances where suicide is committed in the first two years, the premiums paid by the policyholder will be returned to his or her family.
If you are murdered at the hands of your beneficiary, he or she is unlikely to reap the rewards they’re hoping for.
The beneficiary will be thoroughly investigated before receiving the policy’s proceeds. Most states have a “slayer statute,” a law preventing suspected murderers from inheriting the benefits of a life insurance policy.
With this law, any evidence of foul play on the part of your beneficiary should lead to a denial of access to your policy’s death benefit.
Tips for Designating Beneficiaries
- Choose multiple beneficiaries: It’s wise to choose both a primary and secondary beneficiary.
- Be specific: Include their full name(s), date of birth, and/or social security numbers, and avoid using generic terms such as “wife” or “children.”
- Review your policy: Every few years, especially after life-changing events such as marriage, death, divorce, or the birth of a child, take the time to reconsider your designations.
- Assign percentages: Avoid a sticky situation by ditching dollar amounts in favor of percentages.
- Line up guardians: Don’t list minors as recipients of your policy unless they have legal guardians in place.
- Understand estate laws: Don’t name your estate if there are specific family members you want to gift. Your creditors may be able to file claims against your estate.
- Avoid creditors: Don’t name a creditor as a beneficiary. Instead, select a loved one who can use the funds to settle debts and benefit from the remainder of the policy.
Naming a life insurance beneficiary should be an easy, straightforward process.
Nevertheless, be sure to carefully consider the reasoning behind all of your choices and consult your accountant, financial planner, and attorney to discuss the legal, financial and tax implications.