Your life insurance beneficiary receives the death benefit if you die while the policy is still in force. This means choosing your beneficiary is an important step in owning a life insurance policy. After all, your beneficiary is probably the reason you have life insurance in the first place.
But deciding who gets the payout may not be as simple as you think.
A beneficiary can be a spouse, dependent, parent, or anyone you choose. Entities such as a charity, a religious organization, or an educational institution can also be designated as a beneficiary. You can also name your estate as the policy beneficiary.
There’s a lot of flexibility in how you designate beneficiaries. You can name more than one beneficiary to share the payout and assign an amount or percentage of the death benefit to each. You could also have backup beneficiaries by naming primary and contingent beneficiaries.
Keep in mind that some state laws may require you to name your spouse as your primary beneficiary, getting at least 50% of the benefit. In some states, you may be able to name someone other than your spouse as a beneficiary if you have documented permission from your spouse to do so.
Aside from minors, insurers don’t have rules on who you name as a beneficiary. While it’s not a legal or insurer restriction, we recommend that the policy owner, person insured and beneficiary are not all separate entities. This is because the IRS might view any proceeds from the death of the person insured as a gift from the policy owner to the beneficiary, meaning they can be taxed.
Similarly, we don’t recommend that you make a creditor a life insurance beneficiary, as is common with credit life insurance policies. Instead, designate the beneficiary as the person who would pay a debt. For example, by making your spouse the beneficiary, they can decide whether to use the death benefit to pay the mortgage (and continue living in the house) or for a more pressing expense.
There are two options when designating a beneficiary:
Primary vs. contingent beneficiary:
If your intended beneficiary is a minor, some insurers won’t let you directly name them as a life insurance beneficiary. In these cases, you can either:
If your intended beneficiary is a long-term dependent, such as a family member with special needs, you will likely want to set up a trust for them as well, even if they’re not a minor. They could be disqualified from Medicaid and Supplemental Security Income by receiving over $2,000 as an inheritance. By setting up a trust as your beneficiary, you can avoid this issue and the trustee will manage the payout on your family member’s behalf.
It’s a good idea to review your life insurance beneficiaries at least once a year to make sure you’re still comfortable with who you have listed. Divorce, marriage or the death of a loved one are all instances that may cause you to reconsider your beneficiaries.
While a life insurance policy is a contract, it’s important to remember that it’s not set in stone. It’s a living document—at least while the policyholder is alive—and its beneficiaries can usually be changed at any time with either a request form or online.
If you and your spouse are ending your marriage, it’s in your best interest to know how life insurance works during a divorce. A settlement might include a stipulation that one or both spouses maintain life insurance, especially if they’re going to owe alimony or child support.
The IRS doesn’t consider death benefit proceeds as taxable income. However, interest earned on that sum after you pass is taxable. For example, asking the life insurance company to delay the transfer of the death benefit for a few months will cause the lump sum to earn interest while it is held. If you elected to receive monthly installments, the funds that have yet to be disbursed also will accrue taxable interest. If you plan on naming your estate as the life insurance beneficiary, the amount could push the estate into a federally taxable zone. The 2022 limit before an estate is taxed is $12.06 million.
Assigning beneficiaries is essential to make sure the death benefit is paid as you intend. If you fail to name a beneficiary on your life insurance policy, that money will be transferred to your estate when you die. It will be up to a probate court to distribute your assets to your heirs, a time-consuming process that could result in legal fees and other expenses that diminish the size of your estate.