When you purchase a life insurance policy, either whole or term life insurance, you will have to specify one or more beneficiaries for the policy payout if you pass away. In most circumstances, the named beneficiaries are the final say in how the policy pays out, but there are instances when a life insurance policy can be contested.
Similarly, there is a limited contestability period when you first purchase the policy during which certain causes of death will void the policy. Most commonly, this happens when a person commits suicide during the first 6 months to one year of having the policy, but the contestability period varies from state to state and by insurer, and could be as long as two or three years. This is also the period of time when the insurance company can terminate a policy because of errors you made when filling out the application.
When the claim matures, the life insurance policy can be contested by the beneficiaries or even by those who were not named. This could occur when your children or other dependents feel they are not getting the share of the policy they feel they deserve. It can also happen when a relative or dependent was left out of the policy but still feel they deserve a portion.
To avoid your surviving loved ones from contesting the policy payout, set it up to pay into a trust fund. This also keeps the money from the policy in a tax-deferred status, saving the benefits of the policy for where they were intended instead of giving a hefty portion to the government. This does not make the payout tax-free, but it does circumvent paying estate taxes on it.