Should you name your children or your estate on your life insurance policy?

When it comes to naming the beneficiary of a life insurance policy, there is no one-size-fits-all answer. There are plenty of variables to consider but they fit individual people differently. A reader recently wrote to me asking about potential beneficiaries. Read on to see his question and my comments.

"I am trying to figure out if it is best to leave my life insurance to my children with a named trustee or to a trusted adult. Is there any advice you have?"

I wouldn't presume to advise you since I don't know anything about you or your family or your estate, but I can provide you with some thoughts about this question generally. There is no right answer that fits everyone in every situation.

If your intention is for the children to receive the life insurance benefits, then I do not like the idea of leaving it to "a trusted adult" and telling them that it is really for the children. Certainly you trust the person, but if you name that person as the beneficiary, you are not creating any legal right in your children to claim the money if something goes wrong. Even a trusted adult can pass away, lose capacity, be taken advantage of, or succumb to extreme financial pressures. If your children are not named as the beneficiaries of the policy, they will have absolutely no legal recourse to try to recover the insurance proceeds.

I don't agree with documents saying one thing while your intention is really something else.

When you say you might leave your life insurance to your children with a named trustee, there are two ways of doing that. One is to name the children and the trustee right on the policy itself with the insurance company. The other is to name your estate as the beneficiary of the policy and to use your will to bequeath the money to the children.

As a general rule, you will have more flexibility and more control over the funds if you gift your children through your will.

For example, let's say you have three children. You name them all on the policy. Each of them will receive  his or her share on the day they reach the age of majority. But let's say you think that's too young for them to receive that much money. Perhaps you think it would be best to give them half the money at age 21 and the rest at age 25. You can't do that on your insurance policy, but you can do it through your will.

Let's say that one of the children passes away before reaching 25. The policy would then be divided between the remaining two children, if they were named directly on the policy. However, if you had named your estate as the beneficiary and left the residue of your estate to your children, you could say in your will that if one of  your children passed away, his or her share could be given to his or her children.

You could, of course, set up a separate insurance trust to control all of the variables such as the age the children receive their funds, whether the trustee can encroach on the funds, and other important issues. But why do this when those exact issues are already being covered in your will?

These are just examples, not an exhaustive list. Your will can be used to craft the trust you want. In other words, you can use your will to personalize the gift to the children to suit your goals and your children's needs. It also helps you to integrate the insurance policy proceeds with the rest of the inheritance  you are leaving to your children. For example, if you were also leaving your children other assets such as a share of your home, bank accounts and investments, you might find it easier to deal with just one source of money (your estate) than to deal with two (your estate and the insurance company).

Having life insurance paid into your estate may actually help your children to inherit other assets that might otherwise not go to them. For example, if there is a cabin in the estate but not enough cash to pay the capital gains tax, the cabin would probably have to be sold to cover the taxes. But if the life insurance had been left to the estate, it could be used to pay the taxes. Then your children would have the opportunity to inherit the cabin.

There is a drawback to leaving the insurance proceeds to your estate, because any debts and liabilities you have will be paid out of the estate. Therefore if you should pass away leaving a huge lawsuit or tons of debt, the insurance proceeds are just as exposed as the rest of your assets. If you had left the insurance proceeds directly to your children, those funds are not likely to be accessible to creditors.

The best way to decide what's right for you is to discuss your life insurance with your estate planner in the context of your entire estate to see how the pieces fit together.