Facing the loss of a loved one is the most traumatic event that many people ever have to experience. As fellow Fool Selena Maranjian points out in her article on minimizing funeral costs, when people make decisions about financial matters while they're grieving over the death of a family member, they are particularly vulnerable to costly suggestions based more on emotion than on practicality.

One solution that many people in the funeral-services industry recommend is prepaid funeral and burial contracts. While making funeral arrangements in advance has a number of advantages, it doesn't always give you exactly what you pay for. If fact, there have been numerous instances of abuse of such arrangements, despite the regulations in place among state governments.

The basics of prepaid plans
The general idea of prepaid funeral contracts is that by making all of your funeral arrangements in advance, you ensure that your wishes are carried out and that the costs of your funeral won't impose a financial hardship on surviving family members. Depending on your state's particular laws, you may be able to specify in great detail the type of funeral you want.

What happens to the money you put out for a prepaid funeral contract also depends on state law. Most states require funeral homes to deposit the proceeds of prepaid funeral contracts into special trust accounts that keep the funds separate from their general accounts. This separation is intended to prevent fraudulent funeral-services providers from embezzling your funds and to protect your money from creditors if the funeral home goes out of business. However, these trusts generally don't give you any options on how the money you pay is invested. In fact, many states require trust funds to be invested in extremely conservative ways that provide only nominal returns.

Advantages of prepaid plans
Prepaying your funeral costs carries two main advantages. The most important advantage is that they remove the guesswork for your surviving family members after your death. Since your family will be able to look at the choices you've already made, they'll be confident that your funeral will be exactly as you wanted. In contrast, circumstances in which family members have no guidance about a loved one's wishes carry the highest risk of allowing disreputable professionals to take advantage of their grief.

The other primary advantage is that in some cases -- but not all -- you can lock in the current price of funeral services before they rise over time. In some cases, though, your family will have to pay any additional costs that may accrue in the interim. Therefore, you must carefully read through the prepaid-contract documents to be sure you understand exactly how the arrangement will work after your death.

Potential pitfalls
There are also downsides to prepaid plans. First, given the significant cost of funeral arrangements, these plans require you to lock up a considerable amount of money, often for the remainder of your life. You'll lose not only the amount you pay for the contract but also any interest, dividends, and capital gains you could have earned if you had invested that money on your own.

Also make sure that your prepaid plan isn't tied to a particular location. Most plans have provisions that make it possible for your funeral to be held anywhere, but you should still ask questions about how the provisions for your particular plan work.

And remember, if you ultimately decide not to buy a prepaid plan, you can still tell your loved ones ahead of time exactly what you want at your funeral.

Prepaid funerals and Medicaid
Perhaps the most valuable use for prepaid funeral arrangements is in helping poor families preserve their assets while preparing to receive Medicaid benefits. In general, Medicaid provides benefits only to people with little or no financial resources. If a person has money set aside for funeral costs, Medicaid agencies would usually require the person to spend that money on immediate medical expenses and nursing-home costs before the benefits could begin.

Money paid into prepaid funeral plans, however, is excluded when determining Medicaid eligibility. As a result, Medicaid recipients can still pay for their own funerals rather than forcing surviving family members to find ways to cover the costs.

The bottom line
It's important to remember that funeral services are big business for companies in the industry, including Stewart Enterprises (NASDAQ:STEI), Service Corp. (NYSE:SCI), and Alderwoods Group (NASDAQ:AWGI). So planning ahead can help you and your surviving family members. From a financial perspective, on the other hand, many people might do better holding onto their money and investing it themselves.

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Alderwoods is a Motley Fool Hidden Gems recommendation.

Fool contributor Dan Caplinger has worked with clients who have had both positive and negative experiences with prepaid funeral arrangements. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy doesn't make you prepay for anything.