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Life Insurance and Your Children

Under normal circumstances, you will live to see your children grow to adulthood before you pass on. But sometimes things don’t work out as we hoped – and we leave a large life insurance benefit behind.

Normally, a married person who has children would name his or her spouse as beneficiary. It’s up to the surviving spouse to manage the large tax-free life insurance death benefit for herself and the surviving children.

But suppose you survive your spouse? Or suppose you break up, or you find that your spouse just can’t be trusted with large amounts of money? Or suppose you don’t have a spouse at all?

Many parents make the mistake of naming their children directly as beneficiaries on their life insurance policy. But this could become a huge problem after your death. Here’s why:

The life insurance company cannot give a large cash award to a minor child. If you die, and your child is listed as your beneficiary, the life insurance company will hold that money back until a legal guardian is appointed.

This could be a time-consuming process. Meanwhile, that life insurance money may be desperately needed.

You could name a friend, or a sister or brother as the beneficiary, in exchange for a promise to use the money for your children’s sole best interests. But that’s only as good as the beneficiary’s word. If the beneficiary took all the money that you meant to fund your children’s’ futures, and blew it in Vegas, your children would have no recourse.

What’s more, there are some life insurance agents who aren’t aware of a pretty easy workaround. (Yes, they get tested on this stuff when they get their insurance license – but I saw an agent working just today – a retired sergeant major selling supplemental life insurance to a group of National Guardsmen – who didn’t know how to handle the issue.)

Uniform Transfer to Minors Act

The Uniform Transfer to Minors Act, or UTMA, allows you or a life insurance company to establish a custodial account on behalf of your children. You would name the custodian on the trust – someone you have a great deal of confidence in to handle the money responsibly and faithfully on behalf of your children.

This allows the life insurance company to release the funds immediately – and they become available to help support your children within days, under normal circumstances (though SGLI is notoriously slow to issue death benefits).

How it Works

When you apply for life insurance, or when the company delivers the policy, you will have a spot on the application or on a separate form that prompts you to establish a UTMA custodial account (a few states operate under a similar but older arrangement called UGMA, for the Uniform Gift to Minors Act).

Rather than name your children as primary or secondary beneficiaries directly, they should go here.

You will also be prompted to select a custodian for that account.

If you die, the life insurance company will set up a custodial account in your children’s names, with the beneficiary you select having sole discretionary authority over those funds. Some companies will issue a paper check to be deposited into that account. More companies lately will simply wire the money to the account they set up, and provide the beneficiary with a checkbook for the fund.

From that point, the custodian you select has a fiduciary duty to use the funds solely in your children’s best interests. If they steal or misappropriate funds from your children’s custodial account, your children have a right to petition a court for an accounting, and even sue the custodian for the squandered or stolen money.

Isn’t the UTMA a kind of trust?

Not quite, though they sometimes serve similar purposes. A trust is a much more sophisticated and flexible vehicle that gives you, the grantor, many more options and is more flexible. They also cost a lot more to set up than an UTMA or UGMA.

From a planning point of view, the main difference between an UTMA and a trust is the question of ownership. Assets in an UTMA account are technically your children’s property. Which means they automatically get to take full control of the asset when they turn 18 or 21, depending on the state.

Assets in a trust are the trusts’ property, not your children’s property – and you can attach more strings to a trust, such as requiring your children to attend or complete college before gaining control of the funds. Your children’s creditors also cannot sue for assets held in a trust, but they may be able to attach assets held in custodial account in a lawsuit.

Furthermore, because you can have the trust remain in possession of the assets for as long as you like, you don’t run the risk of suddenly putting large amounts of money into the hands of an immature 18 or 21 year-old. For all you know, your precious little toddler princess will be struggling with drug addiction in 16 years. Suddenly inheriting a six-figure death benefit could enable her to squander all the money very quickly – and it may even kill her.

With a trust, you can have the trustees hold back the money until she gets her life together.

By transferring assets to an UTMA, you could hurt your children’s’ chances of qualifying for need-based financial aid for college, under the federal financial aid system. This is because the Department of Education expects college students to contribute a much higher percentage of their own assets to college than parents do. Parents may well want to keep some separation between the child and the life insurance proceeds for that reason.

If the amount involved is quite large, it may be worthwhile to pay the added costs to establish a trust. Only a licensed attorney can draw up the paperwork.

If you’re on a budget, or the amount of money involved is generally small, then you may want to lean more towards the UTMA solution.

But don’t go down the blind alley of leaving large amounts of money directly to children. It doesn’t work!

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