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Avoiding the most common life insurance planning mistakes
Review your life insurance policies and other accounts to prevent these common errors. Part 1 in a series.
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I felt bad for Mary, as she continued crying in my office, but there was little I could do. She had been referred to me by a friend. Mary’s problem was unfortunate and financially devastating, but it could have been avoided with a 15-minute life insurance fire drill.
In a nutshell, Mary’s husband Bob, now deceased, had somehow managed to disinherit her from the one major survivor asset he had owned, a $1 million life insurance policy. It seems that his first wife was still named as primary beneficiary, not Mary, his second wife. Bob had purchased the insurance online, had no broker to work with and had simply forgotten to change the beneficiary to Mary. Bob and Mary had other assets, so she was not left penniless, but excessive debt outweighed their accumulated value. The life insurance policy was to be Mary’s source of continuing income at Bob’s premature death. Unfortunately, Bob was guilty of a life insurance mistake, and now Mary and their young children were paying the price.
This type of mistake is one of a dozen or so you could be committing right now — some maybe without realizing it. Bob did not plan to disinherit his family. Neither would you, right? But have you? When was the last time you checked?
In the 30-some years since I began working with clients in the financial planning area, I have witnessed many instances in which lack of basic planning and/or follow-up with personal and business life insurance resulted in unwanted and sometimes catastrophic outcomes, many of which included dire tax results. I have seen minor errors that led to inconvenience, expense and aggravation. I have seen more serious errors, such as Bob’s, that upended a family’s financial security or destroyed a physician’s business plan of continuity. What is most unfortunate is that these and other mistakes could have been avoided with little or no difficulty. Many times it was because the people involved never even knew a gaffe was occurring until it was too late.
Steve Leimberg, JD, CLU, my friend and national writer of and speaker on almost anything financial, addressed such problems in May 2004 in his publication “The Ten Most Common Life Insurance Mistakes And How To Avoid Them.” With Steve’s permission, I would like to enumerate for you a few of those mistakes from his list of oft-committed but avoidable life insurance planning errors, along with a few others I have personally observed in servicing the public’s life insurance needs.
Mistake No. 1: Naming your estate as beneficiary
Many people leave beneficiary information blank when completing applications for life insurance because they may not be certain who they wish to name (especially with contingent beneficiaries). They expect to fill in the blanks later and often do, but sometimes they forget to go back. Failing to name a specific beneficiary exposes the proceeds of the policy to possible state inheritance taxes where none might have existed or perhaps to a higher rate than otherwise would have been imposed had there been a named beneficiary.
Second, leaving life insurance payable to the estate, in most instances, guarantees that the money will be unnecessarily delayed during the probate process (which can take months, even years) with its inherent expense and consternation.
Third, when the estate is named beneficiary or when the estate is the default beneficiary if no one is specifically named, creditors may come calling. Although many states exempt from creditors all or certain amounts of life insurance proceeds left to the estate, why give them any chance at nabbing monies that should go to your spouse, children or grandchildren?
Do all of your life insurance policies contain up-to-date beneficiary designations? Or are some of those lines still blank? When did you last check ? How about your IRAs, group term life insurance at work, 401(k) accounts, 403(b) accounts? What about your SEP-IRA or SIMPLE-IRA? These assets all pass to heirs via beneficiary designations. Are your heirs properly named? Have you added family members at birth, or are your young children unintentionally disinherited? Some IRA/401(k) custodian beneficiary forms only provide space for primary beneficiaries so children are left out. How about yours?
Mistake No. 2: Failure to name at least two backup beneficiaries
Who backs up your primary beneficiary should he/she predecease you, if only by a few minutes, as in a car crash? Did you leave the contingent beneficiary designation blank to give more thought to it and forgot to add it later? If so, your estate steps in with the needless complications listed in Mistake No. 1.
But there is more to it and that is why it is Mistake No. 2. Make sure you employ what Steve Leimberg calls the “Rule of Two.” Name at least two backup beneficiaries as contingents. If all beneficiaries may at some time travel together – as families do – then make sure a third level of contingents is named, such as other non-immediate family members or, if none, some charity or other entity. Estate attorneys often refer to this expanded list as the “nuclear option.” Unfortunately, in this age of global terrorism, whole families face potential danger. So think beyond the first tier of beneficiaries to the “Rule of Two.” Do this for all items of beneficial interest, such as those named in Mistake No. 1.
Mistake No. 3: Making policy proceeds payable outright
Steve Leimberg insists that the “improper disposition of assets is one of the most frequent and serious of all estate planning errors. It occurs when the wrong asset goes to the wrong person (as in Bob and Mary), or in the wrong manner, or both.”
The first question is, who should receive the proceeds of the life insurance? How much of the proceeds should they receive? And how should they be provided – outright or in trust? It is not unusual for parents to feel that their estate, of which life insurance represents ordinarily a significant part, should be divided equally among their children. And so they proceed in that direction. They adopt wills that leave assets equally to their heirs, with life insurance policies set up the same way. Sounds OK, but often it is not that simple. My experience concludes that equal is not always equitable. For example, your younger child, age 5 years, may need more assets for a longer period of time than an older sibling who may have already graduated from college and benefited from your bounty. Your daughter may be struggling from a difficult divorce while her brother may be a successful surgeon and financially well-off in his own right. Should they get equal shares of your estate? Maybe, but maybe not.
Further, in your estate plans, you may be leaving assets and life insurance proceeds outright to your children, ie, no strings attached. But if your children are minors, they cannot inherit the property or proceeds directly, and guardians or custodians will need to be named, at the child’s expense. But that is not all.
I have talked to many parents who seek control over education funds because of potential mistrust of a child’s behavior at age 18. They fear the child, if left to his or her own devices, will take the money, buy the Harley-Davidson motorcycle and run off. Nevertheless these same parents are planning to bequeath inordinate amounts of insurance proceeds directly and unencumbered to that same spendthrift child or grandchild. There is something wrong with that picture.
Maybe the child is emotionally incapable of handling a huge cash windfall from insurance and investing it. Maybe there are special needs for a disabled or handicapped child or grandchild and that child ought not to get insurance proceeds outright.
What about the spouses of your children? Are their marriages OK? Leaving proceeds outright to heirs means those assets may be held hostage in a nasty divorce. And let us not forget those demons of the deep– the creditors of your children or grandchildren. Unprotected assets may be attempted to be taken by those who might sue your child or grandchild.
You can avoid much of this bad stuff by considering a trust or other legal instrument to provide beneficiaries with a safer and more secure manner of estate disposition. Trusts can be imminently flexible and can provide shelter for life insurance proceeds and other assets from “creditors and predators, in-laws and out-laws,” to repeat a Leimberg phrase. Why not visit with your estate attorney for a checkup that includes a review of exactly how you are leaving assets to your heirs, and to which heirs and in what amounts those assets will go. After all, it is only your lifetime accumulation of savings and investments and insurance that is in the balance.
Mistake No. 4: Failure to check policies at least every 3 years
If Bob had checked his policies, Mary would never have been disinherited. Too often I see children unintentionally excluded from policies, especially when the contingent beneficiary designates children by their actual names and not as “all children of the insured,” as many life insurance agents are wont to do. Being name-specific means that only those listed receive proceeds. Children born afterward, unless you check, are left out. These are usually the youngest children, too, who need the money over the longest period of time.
Here is another issue to review. Check to see if the beneficiary designation is “per stirpes” or “per capita.” The former means “through the roots” in Latin. So if you have three children who all are married with families and one of your three children dies, that deceased child’s share goes to the grandchildren. With “per capita,” the proceeds would be divided between your two surviving children, and your deceased child’s children would be disinherited. Perhaps that is the way you want it. Perhaps not. What do your policies say? Your IRAs, your 401(k) or 403(b)? If you have not checked, how will you know? In Delaware, if left unstated, “per capita” is the default. That could be unfortunate for grandchildren, especially since life insurance may well represent a huge part of the deceased’s estate. What does your state say? Why not call your agent, broker or financial planner and schedule a life insurance fire drill, then mark a date on your computer scheduler for every 3 years to revisit the issue? If you do not, you will forget.
Mistake No. 5: Think twice about cashing in or deliberately lapsing your life insurance if you are age 65 or over
A recent development in life insurance planning is the so called “life settlement.” This approach is used not when someone wishes to buy or modify life insurance; it is an option to consider when terminating an unwanted or unneeded life insurance policy. Policyholders age 65 or over with face amounts of $250,000 or more can go to this new “secondary market” for life insurance. That marketplace, made up of corporate buyers, will consider purchasing the policy for an amount of money. The actual purchase price is determined by several items, the most important of which is the health of the insured. Life settlements are not viaticals that seek to purchase policies from terminally-ill insureds. Rather they are economic transactions between a willing buyer and a willing seller, the latter not necessarily having to be in poor health.
For example, Bill, age 65, is retiring and can no longer afford to keep his $1 million life insurance policy. If he cashes it in, he would get back his $175,000 cash value, which he could use for retirement income. Until life settlements appeared in the marketplace, that was Bill’s only viable choice. Among the other choices he now has is the opportunity to price the policy in the secondary market. His health is just OK. He discovers he can receive a life settlement of $325,000 for the policy from the secondary market, which is much better than receiving just the cash surrender value of $175,000. Bill will incur some tax-free money from the settlement, some ordinary income and some capital gains.
So if you are 65 or older, before you toss out your old policies, even term policies, check out the “life settlement” approach. Further, if you own a policy that is “blowing up” from lower earnings and higher internal mortality costs, you may be able to rescue the policy through a life settlement.
If you would like more detailed information on life settlements, please feel free to send me an e-mail request, and I will forward you an informative brochure on the subject.
Next time
In the February 1, 2006 issue we will look at five more life insurance planning mistakes.
For Your Information:
- Kenneth W. Rudzinski, CFP, CLU, ChFC, CASL, a certified financial planner in Wilmington, Del., has been cited in Money magazine and in Who’s Who in Finance & Industry. He can be reached at The America Group, Foulkwood Professional Building, 2036 Foulk Road, Suite 104, Wilmington, DE 19810; 302-529-1320; e-mail: kenr@americagroup.com.
- Brent C. Fuchs, CFP, CLU, ChFC, is a certified financial planner at the America Group in Wilmington, Del. He can be reached at bcf@americagroup.com.
- Steve Leimberg, JD, CLU, is the author of “The Ten Most Common Life Insurance Mistakes And How To Avoid Them.” He can be reached at www.leimbergservices.com.