When buying a life insurance policy, most people name their spouse as the primary beneficiary, the person who receives the payout if the policy holder dies. Often policy holders will list their minor children as secondary beneficiaries. However, there are situations where it might seem to make sense to name the children as primary beneficiaries.
For example, you and your spouse might be old or have health issues that could cause you to die before your children become legal adults. You may be divorced and not on good terms with your former spouse. Or you may have a special needs child that will require financial support as an adult.
All of these would appear to be logical reasons for naming your children as the beneficiaries of your life insurance. And you can certainly do so if you wish. Only problem is, it is not recommended – for several reasons.
In most states, children who haven’t reached the legal age of adulthood (18 or 21, depending on the state) are not allowed to own property or financial gifts, such as an inheritance, above a very small amount. If you die while your child is still a minor, the death benefit from your life insurance policy can’t be legally transferred to your child – even if he or she is the primary beneficiary. Your child won’t have the authority to take control of the funds. And your life insurance company isn’t allowed to pay the proceeds directly to the child.
What happens to the money from the death benefit if the beneficiary is a minor?
If you haven’t designated a responsible adult to manage the assets or created a trust to hold the money until your child comes of age, the state court will take over and appoint a guardian to control and manage the assets. This can be an expensive and time-consuming process. Also, it puts someone you don’t even know in charge of your life insurance proceeds – probably not what you hand in mind when naming your child the beneficiary of your policy.
Protecting Your Child and Your Life Insurance Proceeds
Fortunately, there are several alternatives to having the courts take over the process of transferring the money. If the death benefit is relatively small, say, $20,000 or less, most states will allow a minor's parent or grandparent to request the funds be placed in an account established under one of the following state laws:
These custodial accounts are specially designed to hold and protect assets for minors until they reach the legal adult age in their state. They also offer tax advantages when investing the funds. Because the assets belong to the minor, part of the investment income is not taxed. The remaining amount gets taxed at the child’s tax rate, not the parents’. Transferring the money to a UTMA offers other benefits as well, including the ability to avoid probate and protect the money against the claims of creditors.
Many states also allow the funds to be placed in a , which functions as a tax-advantaged savings plan for future college costs. In some states, a parent can legally manage very small amounts of money, $5,000 or less, for their minor child.
What happens when the death benefit in your life insurance policy exceeds the maximum limits for UTMA, UGMA and 529 accounts?
Most financial advisers recommend putting the proceeds into a trust managed by a custodian or trustee of your choice. A trust enables you to designate when and how your child receives the money upon reaching adulthood, and the custodian sees that your instructions are carried out. Keep in mind that young adults who suddenly receive a large financial windfall often don’t have the maturity and life skills to manage it well. Choose someone you trust to manage the money properly and distribute it to your adult child according to your wishes.
Why You Need A Custodian
Selecting the right person to be custodian of your minor child’s finances can be a difficult choice, but not naming a custodian can lead to dire consequences.
If a minor child inherits a large sum of money without a trustee, the court is forced to appoint someone to act in that capacity. The person who ends up managing your child’s money could know nothing about your child or your family, which is not the person you want. The court could also impose restrictions on how the insurance proceeds can be distributed or spent, which can cause financial difficulties and unwanted legal problems.
Custodians are especially important when leaving your life insurance death benefit to a minor special needs child. Receiving funds directly from you could negatively impact any government support the child is receiving, even if they are not yet old enough to own the assets. The better approach is to establish a special needs trust in the name of your child, as gifting assets to the trust will not affect your child’s benefits eligibility.
As the owner of a life insurance policy, you can name anyone you wish as the beneficiary. However, before naming your dependent children, make sure you understand all the ramifications, and have someone you respect and trust who is willing to serve as the custodian or trustee until your children reach legal age.
Disclaimer: For informational purposes only. IntelliQuote does not offer tax, legal or investment advice.