Life insurance policies offer the option to designate beneficiaries in the event you pass away – in other words, you get to name who gets the benefits from the life insurance plan. Most people with these policies do have at least one beneficiary named, which ensures a smoother process when it comes to those benefits being paid out.

However, as this 2013 article by Insure.com for Nasdaq states, there are many common mistakes to make when it comes to beneficiaries. For example:

4. Falling into a tax trap

Life insurance death benefits are generally tax-free — except when three different people play the roles of policy owner, the insured and the beneficiary. In that case, the death benefit could count as a taxable gift to the beneficiary, says Amy Rose Herrick, a Chartered Financial Consultant and life insurance agent with offices in the U.S. Virgin Islands and Tecumseh, Kan.

Say, for instance, a wife owns a life insurance policy on her husband’s life and names their adult daughter as beneficiary. The wife effectively is creating a gift of the policy proceeds to her daughter, Herrick says. The person who makes the gift — the wife — is the one who would be subject to the tax, if the amount of the gift exceeds federal limits.

The problem could be avoided in most cases by having the husband own the policy, insuring himself. However the situation can get tricky in community-property states. Consult a financial adviser to decide the best way to structure the policy.

We recommend a full review of your portfolio every three years, which keeps all aspects – including your insurance policies and listed beneficiaries – as up to date as possible. Life changes, such as new grandkids or the passing of family that had been previously listed on the policy, demand the most up-to-date directions for any probate proceedings.

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