Buying life insurance isn't the most complicated task to undertake, but it might not be as simple and clear-cut as you think. For example, when it comes to your beneficiaries, there are a lot of things you can do wrong.
For starters, consider who you're designating as a beneficiary. Some folks don't designate any beneficiary, which is not recommended. Do that, and the proceeds from the policy will pass on to your estate and will go through probate, which can be a lengthy affair. (It can also be costly, such as if creditors are going after your estate. They typically can't access the insurance payout, but if it ends up in your estate, they can.)
Even if you assume that your spouse will end up with the money anyway, it's nevertheless smart to explicitly name them as your beneficiary. But don't stop there – naming only one person as your beneficiary isn't the best option, since that person might expire before you do. Or, if it's your spouse, you might both die at the same time, such as in an accident. (These are terrible things to consider, but terrible things do happen – which is why insurance exists in the first place.) So name a secondary, and even tertiary beneficiary. They won't be sharing the policy payout unless the primary beneficiary isn't around.
There are a few other things to know when it comes to your spouse and your life insurance policy. For example, if you live in a community-property state and you don't want to name your spouse as your primary beneficiary, you can't do so without his or her blessing.
Finally, if you divorce or become widowed, remember to revisit your policy and to think through your beneficiaries again. The current designation(s) may no longer be possible or desirable.
Naming children as beneficiaries is common, but it can be a bit tricky. For example, if your child is a minor, he or she can't receive the policy proceeds as an adult would. Thus, you might need to set up a trust to be the beneficiary, or you might make use of a custodian who could administer the assets. This is an issue that an estates-and-wills lawyer can help you with.
If your children are young adults who can receive proceeds without any problems, give a little thought to whether they will handle the windfall well. It would be a shame if the money isn't used in a way you would like, such as helping them buy a house or seeding an investment account, and is instead spent on clothes, cars, or entertainment. If this is a danger, you might opt to have the benefit paid in installments, or have it paid into a trust.
Another consideration is how you divide the payout between multiple children or grandchildren. If you have two children, and one has given you five grandchildren while the other has just one child, will you have the payout dividend 50-50 between your children, having each one's portion divided between or given to their children if they're not alive when you die, or would you want the money divided equally between all beneficiaries? Think through your preference.
Be careful, too, if you're taking out a policy on your spouse and naming a child as beneficiary, no matter the child's age. That's because life insurance payouts are generally tax-free to a beneficiary – as long as they involve two parties, and not three. Thus, if you, your spouse, and your child (or some other third party) are involved in a policy, the benefit is more likely to be taxable, due to the "Goodman Rule," described by MetLife like this: "Estate, gift and generation skipping transfer taxes may also apply to life insurance proceeds — with rates potentially as high as 40%. The Goodman Rule treats owners who have a third party beneficiary, and are not the insured, as having made a taxable gift of the death benefit to the policy beneficiary."
There are a lot of details related to the taxability of life insurance -- for example, a payout that goes directly into an estate is generally taxable -- so consulting an estate pro or financial planner can be quite helpful here.
Another consideration is that if your beneficiary has any special needs and is receiving or expects to receive Supplemental Security Income or Medicaid coverage, receiving your policy's payout could nullify their eligibility. Government benefits are often tied to financial circumstances. Again -- a professional can guide through this issue, perhaps helping set up a trust to work around it.
A last word of warning is this: tell whoever your beneficiaries are that you have a policy and they're named in it. Be sure they are aware of where the paperwork is, too.
A life insurance policy is a great way to provide for your loved ones and anyone who depends on you for income. Just make sure you've set it up to do exactly what you want it to do.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.