Should you name your minor child as your life insurance beneficiary?

If you recently became a parent, the safety and well-being of your child is paramount. It is no wonder that the birth of a child is usually a motivator to get life insurance coverage. Most people get life insurance to cover the mortgage, education, and other expenses so that their family can continue after they die.

• Naming a minor child as your life insurance beneficiary is not recommended.
• Life insurance policies cannot make a distribution to a minor child.
• It is better to select an adult guardian or set up a Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) account.
• The best option is establishing a trust for your child and naming the trust as the beneficiary.

Most couples name their partner or spouse as the beneficiary of their life insurance, but some parents may want to name their minor children as life insurance beneficiaries instead. However, naming a minor as a life insurance beneficiary can cause significant complications. Instead, consider naming an adult guardian or establishing a trust as the beneficiary of your life insurance.

Should you name a minor child as a life insurance beneficiary?

Once you have selected a life insurance policy, you will need to name a beneficiary of the policy.

"A beneficiary is the person or entity you name in a life insurance policy to receive the death benefit," according to the Insurance Information Institute (III). The Institute noted that "you can name: one person, two or more people, the trustee of a trust you've set up, a charity, or your estate." 

There are several potential issues

In many cases, minor children cannot directly receive the proceeds of a life insurance policy. Instead, the state could appoint a legal guardian if you hadn't done so already, which can be a lengthy and costly process. The guardian would then determine how the money is managed and spent  —  and it may not coincide with your wishes.

"If you have a special needs child or adult you care for, inherited funds from you or anyone else may put their government support in jeopardy. This may disrupt the care and support programs they depend upon for their daily and future care," according to New York Life.

If you are a single parent, also consider whether you'd want the non-custodial parent named the court appointed guardian of the life insurance funds for your child. What if you're divorced? Do you want a stepparent to be appointed your child's guardian? I have seen relatives come out of the woodwork and volunteer to be guardian when money is involved.

Three alternatives to naming a child as beneficiary

You have three options instead of naming your child as the life insurance beneficiary:

1. an adult guardian;
2. a Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) account;
3. a trust established for your minor.

There are advantages and disadvantages with each option.

You can name an adult guardian — but be careful

Your guardian is good with your kids, but they are not good with money management. This is a common issue. The point of selecting a guardian is to preserve your child's inheritance until they become an adult. The advantage of naming an adult guardian as the life insurance beneficiary for your minor child is that you avoid the legal process that would happen if you named your child your beneficiary.

The disadvantages of naming an adult guardian are not knowing whether the guardian will honor your wishes and be financially responsible. If your guardian is not financially responsible, then there is a possibility that the funds will be misused.  

Money does funny things to people  — it's like the ring in "Lord of the Rings" —  activating a person's worst impulses. For this reason, it is not recommended naming an adult guardian as the life insurance beneficiary for your minor child.

Set up an UTMA account

The Uniform Transfers to Minors Act (UTMA) and Uniform Gifts to Minors Act (UGMA) are ways parents can ensure their children receive proceeds from a life insurance policy (or other assets, such as mutual funds, stocks, bonds etc). Under them, an adult sets up an account for a minor at a life insurance company, bank, or other financial institution. A custodian, named by the parents, controls and manages the assets for a minor until the minor reaches the age of majority in that state (usually between 18 and 21). At that time, the assets are turned over to the adult child, who can use the assets in any way he or she chooses.

The advantages of a UTMA or UGMA are its simplicity and that it allows for other assets to be included, like stocks and bonds. The disadvantage is that the minor can receive the funds as soon as they become an adult — usually 18 years old — and financial responsibility and an 18-year-old are not always synonymous. 

Establish a trust 

A trust can be a more detailed arrangement than a UTMA or UGMA designation, and could provide increased control over how assets can be used. For example, a trust can be established to receive and manage the life insurance proceeds on behalf of minor children or adult family members with special needs. In this situation, the trust is designated the beneficiary of the life insurance proceeds.

The disadvantage to a trust is that it is more expensive to set up because you will need to hire an estates attorney. Although setting up a trust is more expensive, it gives you more control over how the funds are spent and when your child gets access to the funds. Because you can select a bank or money manager as the trustee, there are additional safeguards in place to guard against misuse of funds.

Most people who establish a life insurance trust for their children do not have their children receive full control until the child is 25 years old. A trust can have the trustee pay for your child's education and living expenses. You can have the trustee pay a monthly stipend to the guardian. You can have the trust administer a monthly allowance to your child when they become an adult instead of giving full access to the trust funds. The beauty is that you control how the assets are administered.

Remember the movie "Rain Man?" In the movie, Tom Cruise's character is upset that his dad disinherited him in his will. As revenge, he decides to kidnap his special needs adult brother to control the funds. He didn't know that his father established a trust fund and a trustee managed all the funds. This is the benefit of the trust. In case a relative decides to befriend your child for nefarious reasons, the funds are protected by the trustee.

The intention of naming your minor child as your life insurance beneficiary is well placed, but it causes legal problems that can be avoided by utilizing a UTMA or UGMA account, or establishing a trust for your child and make the trust the beneficiary of your life insurance policy.