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If the goal is to be assured that funeral expenses will be covered the best option is number 2(b) below...purchasing a pre-paid funeral arrangement and having it deemed an irrevocable contract by the provider. This is effective in all states.
The more imminent question with regard to owning a life insurance policy is with respect to eligibility, i.e., can you keep the policy when applying for benefits in the first place?
1. Does the policy have cash value? If it does, each state has rules as to the amount of life insurance permitted to be retained without causing an eligibility penalty. For instance in Florida if the total face value (in other words death benefit) of all policies owned is less than or equal to $2,500 then the cash value of the total of all policies is excluded. If the total death benefit of all policies exceeds $2,500 then the cash value of all policies is included in determining the asset test.
2. If the policy would otherwise be countable and you want to fund funeral costs you have two options:
a. Keep the policy as a countable asset but reduce its cash value to below $2,000. This can be done by either borrowing or withdrawing the cash value down to the appropriate level. Keep in mind that premium may have to continue to be paid to keep the policy in force and the Medicaid recipient may not have the income to pay it (some other party will have to pay the premium to maintain the policy). The "spend down" techniques discussed elsewhere will then have to be employed with funds borrowed or withdrawn from the policy to keep the Medicaid recipients assets under $2,000.
b. The policy can be surrendered completely and the cash value used to purchase an Irrevocable Funeral Arrangement with a funeral home. If deemed irrevocable the value of the funeral contract will not be countable as an asset for eligibility purposes and cannot be sought as a source for Medicaid Estate Recovery.
Look at the policy.
Life insurance policies can be sticky for both the Medicaid application and then after death through MERP (Medicaid Estate Recovery Program). To be on the safe side on all this, you &/or your future executor should review with an elder law or probate attorney as state laws make a huge difference in all this.
In general, if the policy has a cash value (which most whole life policies do), then the cash value is included in the spend-down to qualify for Medicaid. If it's a term policy usually no cash value, you disclose the details & amount of the policy in the application. You may be asked whom the beneficiary is too. Sometimes older paid up policy can produce a dividend. (My mom's policy does this). If it produces a dividend, it means "income" and either needs to be spent-down or has to be set up to be re-invested in the policy (so no "income" to the policy owner). The dividend is reported for the annual renewal of the Medicaid too (at least it is for how the renewal form is for my mom TX Medicaid and amortized for 12 mos if large).
For term, whom the beneficiary is will make a difference for MERP. If the named beneficiary is your child or grandchild, they inherit the $ OUTSIDE of probate. So outside of anything MERP can do. But if the beneficiary is your estate then the $ from the policy is within your probatable estate and subject to MERP.
Now some states have probate as a level of claim and paid in order of level. TX does this and burial / death stuff is a class 1 & 2 item & paid before class 7 claim. But other states probate as all claims equal. So MERP could vie for that 10K to go to them first & foremost. It's unlikely as the money would have been paid to FH or policy signed over to FH, but could. Understand?
This is why you hear that you should have a prepaid NCV (no cash value) funeral & burial policy as it assures that policy will pay for FH without any issues. So look at the policy and review with good legal to see what works best to ensure this.