Life Insurance: An Attorney’s Guide to Setting Up Your Life Insurance Policy The Right Way

I recently acquired a client who is being forced to pay my office a significant amount of money and go to court, simply because her father left her children (his grandkids) money through a life insurance policy. In countless meetings, I’ve had to educate parents of the huge mistake they are making by naming their young kids as beneficiaries on their life insurance policy. People think they are making a smart decision and doing the right thing to protect their kids (and grandkids) by naming them as beneficiaries of their life insurance, but in actuality, they are causing a huge headache for their family that will last for years. This common mistake happens so often that I felt it was necessary to spread the word on how to set up your life insurance policy the right way.

Let me start by acknowledging that life insurance is a fantastic financial tool and an essential component of every financial plan. When it comes to estate planning strategies, life insurance offers a simple and effective way to hedge your bets and secure your loved one’s financial future if something should ever happen to you. Yet, it is also extremely important that you know how to set up your policy in the right way.

The beneficiary designations on your insurance policy will significantly impact its effectiveness, how it’s used, and who controls it after you die. In this article, we'll explore the dos and don’ts of naming beneficiaries on your life insurance policy, so that you can ensure that your loved ones will have the funds they need to thrive when something happens to you, instead of a long and protracted legal case.

DO NOT Name Children (minors) As Beneficiaries of Your Life Insurance Policy 

Naming your child or grandchild as a direct (or even backup) beneficiary of your life insurance policy may seem like a natural choice, it may even be suggested by your life insurance agent but trust me it is a bad idea and will result in a terrible outcome for the people you love.

First, a “minor child” is defined as anyone under the age of 18. By law, they are not old enough to hold or manage their own property. Therefore, if a minor child is the beneficiary of a life insurance policy, it guarantees that a court process called “guardianship” or “conservatorship” must occur to name a legal guardian (or conservator) to manage the assets for a minor child until they turn 18. During that time, the “guardian” (most likely their parent), will have to hire an attorney and file an annual accounting with the court every year until the child turns 18, which will cost them money and attorney’s fees every single year. Not to mention, that depending on your state’s law, the guardian may not even be able to access the money or draw from it without the permission of a judge, which will also cost the guardian time, delay, and attorney’s fees in order to file a petition and get the court’s permission to release the money. After all of that, when the kid finally turns 18, the “minor child,” who is just barely an adult receives everything left in the account, outright, unprotected, with no oversight or guidance. This is the worst possible outcome for everyone involved.

If you are buying life insurance, you are doing it to make the life of your loved one’s better. You are literally paying money every single month, simply because you love your family and want them to be financially secure if, or when, something happens to you. Yet, like my current client, instead of a gesture of love and generosity – your relatives will be angry and upset as a result of your kindness – simply because you didn’t take the time to set your life insurance up the right way. You might think the answer is to name a trusted family member or friend as the beneficiary of your life insurance, hoping they’ll use the funds for your kids, but don’t do that!

If you name another adult as the beneficiary for a life insurance policy intended for your kids, your kids will have no legal right to the money – which means the adult you named as beneficiary can use the money however they want and don’t have to use it for your kids at all!

So, what’s the solution? You’ll have to keep reading to find out what to do instead…

DO NOT Name Adult Beneficiaries Directly If You Have Concerns About The Risks

I often tell my clients that there will be less red tape and delay for your insurance company to distribute a life insurance payout if you’ve named your spouse or beneficiaries directly on the policies. Direct payouts to adult beneficiaries may seem straightforward, but can have unintended consequences. Life circumstances change, and the lump sum received from a life insurance policy might be at risk if not managed properly.

One key concern is that your beneficiaries may spend the payout quickly and use the money for things you never intended. The statistics show that an inheritance is typically spent or lost on risky investments within a year. A sudden financial windfall may lead to irresponsible spending, leaving your loved ones without the financial support you intended. Additionally, if your beneficiaries are not financially savvy, they may struggle to manage a lump sum effectively and invest it poorly.

Even if an adult beneficiary is financially responsible and knows what they’re doing when it comes to investing – or knows enough to speak to a financial advisor – life events can put the funds at risk. Because the life insurance proceeds now belong entirely to your beneficiaries, the proceeds are vulnerable to being lost to creditors, lawsuits or even in a future divorce that your beneficiary may go through in the future.

That means that if your beneficiary is divorced, sued, or accumulates debt, all the money they received from your insurance policy could be lost.

Set Up Your Life Insurance The Right Way: Use a Trust

A Trust is an agreement you make with a person or an institution you choose. This person is called your Trustee, and their directive is to manage the assets you put into or leave to your Trust, according to the rules you create. When you are alive and well, you will most likely be your own trustee, managing your assets, for your own benefit. Yet, when you are no longer alive or well, you can name back-up, or successor, Trustees to step in to manage things for your beneficiaries. 

Instead of naming minors or adult loved ones as the direct beneficiaries of your life insurance, you can name your Trust as the beneficiary of your policy instead. By doing this, your loved ones will still receive the funds you intend for them while maintaining control over how the funds are managed and distributed. This ensures that your wishes for your assets and your loved ones are carried out even after you're gone.

How does it work?

A well-drafted Trust allows you to specify conditions for distributing the Trust funds, ensuring that the funds are used for intended purposes such as your beneficiaries’ education, homeownership, or other specific needs. Distributions from the Trust can also depend on the ages and circumstances of each beneficiary, or specify an amount that you’ve instructed to be provided to your beneficiaries each month, year or for particular life events. This level of control can prevent the misuse of funds and promote responsible financial behavior for everyone involved. Plus, assets held in a Trust bypass the probate process, ensuring a more efficient and timely distribution of funds to your beneficiaries. This can be crucial in providing immediate financial support to your loved ones when they need it the most.

And while you can choose to have your Trustee distribute life insurance proceeds directly out to your beneficiaries outright, at specific ages and stages, you may want to provide even more protection for your beneficiaries. One of the considerations we’ll help you make is whether to retain the assets in trust indefinitely, giving your beneficiaries control over the Trust assets, but in a manner that keeps the inherited life insurance protected from lawsuits, future divorces, and creditors.

Set Up Your Entire Estate and Financial Plan In The Best Way Possible

Setting up your life insurance policy in the best way possible for your beneficiaries involves careful consideration of your unique family dynamics, financial goals, and long-term objectives, while also considering potential future problems specific to your loved ones. By doing so, you maximize the benefits of your life insurance to design and proactively create a lasting legacy of financial security and support for your loved ones.

Ensuring that your life insurance policy is handled in the best way possible is only one step in creating a plan for everything you own and everyone you love.  It is my mission to help guide people to create a comprehensive estate plan, which I call a Family, Wealth & Legacy Plan. Our unique planning process will ensure that your wishes are fulfilled and your family's future will be protected, no matter what the future holds. Unlike my recent discussion with my client, where she was sincerely upset by the kind gesture that her father made with good intentions to leave his grandson with a life insurance policy, we will help ensure that the memory you leave behind will be one that you intend and deserve, by educating and assisting you to choose the best options possible for your family and loved ones.  

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This article is a service of Family Wealth & Legacy Legal Solutions (FWLLS). At FWLLS, we do not just draft documents; we ensure you make educated, informed and empowered decisions for yourself and the people you love. That's why we offer a Family Wealth & Legacy Strategy Session™, during which you will get educated and begin to prepare to avoid life’s most common legal problems and get a plan in place to make the best possible choices for the people you love. You can begin by calling our office today to schedule a Family Wealth & Legacy Strategy Session and mention this article to find out how to get this $750 session at a significantly discounted rate, or even for free.