When I mentioned to a colleague that I was going to write about life insurance, she wanted to run the other way! I understand — life insurance is certainly not the most riveting topic. However, life insurance is a cornerstone of many people’s financial plans, and there are nuances that sometimes get overlooked. Let’s focus on four questions you should ask to maximize the benefits of owning life insurance.
1. Have circumstances changed in your life?
If it’s been a while since you’ve reviewed your current life insurance, it’s a good time to do this now — waiting can truly cost you money. How much life insurance is “enough” is unique to each person’s financial and family circumstances, so don’t shortcut this important conversation.
Life moves quickly as families grow and change and so does the need for life insurance. Life insurance death benefits are used for more than just replacing immediate income from the family breadwinners. They can also pay off the mortgage and other debts, cover college costs, create a retirement fund for a surviving spouse, fund a business transfer or be a valuable estate planning tool.
The point is that as you take control of your finances, you need to protect your loved ones against a premature death and have a solid safety net. That safety net can extend to many people, especially in the case of divorce and remarriages.
Specifically, in the case of divorce with future child and spousal support obligations due to you, you would want your divorce settlement agreement to stipulate that your ex-spouse, as payor, maintains a sufficient life insurance policy naming you, as the recipient-beneficiary, to cover all future commitments. Just as important is to be notified by the life insurance company of any policy changes or lapses since you may be depending on this money in the future should something happen to your ex-spouse.
Stay-at-home spouses and caregivers often need life insurance on their lives also since replacing their duties could incur many unexpected costs for the survivor.
2. Are your beneficiaries up-to-date?
Has it been years since you updated your primary and contingent beneficiaries? Below are a few do’s and don’ts when naming a beneficiary — more can be found on 10 common mistakes when choosing life insurance beneficiaries:
• DO designate named individual(s) or a trust to avoid probate and allow death benefits to pass directly to beneficiaries, income tax-free.
• DO NOT designate your Estate since this will lead to proceeds becoming entangled in probate and allow creditors to place claims against the estate.
• DO NOT name minors as beneficiaries since assets will be paid outright to them as soon as they reach 18 or 21, depending on the state.
• DO NOT name a special-needs adult or child directly since this will likely disqualify them from being eligible to receive government benefits.
• DO Understand the difference between per stirpes (i.e., family lineage) and per capita (i.e., by head).
3. Should you consider a Trust?
Designating a Trust as beneficiary for minor children, special-needs individuals or a loved one who has no financial sensibility allows you to specify terms with a more controlled intent. Trusts can be revocable or irrevocable, and we strongly advise working with an estate attorney to establish the appropriate trust for your intended purpose. See 5 Reasons to Consider a Special Needs Trust.
Remember, if you are the owner and insured, the death benefit will be included in your gross estate for tax purposes. Having life insurance owned by an irrevocable life insurance trust (ILIT) allows the death benefit proceeds to be removed from the insured’s estate unless the three-year-look-back rule applies.
ILITs can benefit large estates by minimizing federal and state estate taxes. If the decedent has a large estate and is a resident of a state with a lower state estate tax exemption than the current (2019) federal $11.4 million exemption (which is the case for Maryland at $5 million and D.C. .at $5.6 million), owning life insurance in an ILIT may save substantial estate taxes.
4. Do you know the policy exclusions?
Life insurance policies are contracts, and like any contract, it’s important to read the fine print. Below are some universal exclusions that may prevent your beneficiaries from receiving their intended death benefit:
• The Contestability Period: This is a predetermined time period, usually two years from the date of issuance, where an insurance company has the right to contest any information you submitted, cancel coverage or deny a claim if there were misstatements or omissions made on the life insurance application. Examples include omitting medications you take or unintentionally misstating your tobacco use. You may no longer be smoking cigarettes but using electronic cigarettes or chewing nicotine gum is still considered tobacco use. If you die within the contestability period and an investigation finds that you misrepresented facts on your application, your claim can be denied, even if the cause of death had nothing to do with the actual misrepresentation.
• Material Misrepresentation: This refers to intentionally withholding material information or providing false information to the insurer that would have resulted in them not insuring you and extends during the entire policy term. Life insurance claims can be denied after the contestability period ends if fraud was committed to obtain the policy.
• Suicide Clause: Almost all life insurance contracts have a suicide clause where they will not pay the death benefit and return premiums if the insured commits suicide within the first two years of the policy.
• Other exclusions: Those that are not universal but may be in the fine print of your life insurance policy include: (a) Illegal activity/committing a crime; (b) Dangerous Activities (such as sky diving or car racing); (c) Alcohol and Drug Use and (d) Aviation Exclusion for private plane travel.
Bottom line, life insurance is there to protect your loved ones. Be honest on your application and don’t forget to proactively review your life insurance needs and update beneficiaries based on your current circumstances.
Nina Mitchell is a principal and senior wealth adviser at The Colony Group. She is also one of the founders of Her Wealth®.
