You always think you have everything in order. The will is in place and updated. You just had your trust document reviewed last month. You just verified the stock certificates are in the safety deposit box this week. Wait, did I update my beneficiary on the life insurance policy?
Beneficiary Horror Story
One story that I will never forget was about a client whose mother had just passed away. He was one of three brothers that all got along and equally shared in taking care of the mother. She set up her will so that each of the three sons which would each get a third of her estate when she passed. Everything seemed to be in order, so she thought. Turns out that after her passing the mother’s annuity had the eldest son as the only beneficiary. The annuity happened to represent 80% of her total estate. Of course, the son, knowing his mother’s wishes, would pass the deserved share to the other brothers, right? Sadly enough, this was not the case. The brother suddenly felt he deserved it because he was the eldest. This of course damaged the family to this day.
Don’t Forget About the Retirement Plans
Annuities are not the only item that could have this fate. Retirement plans from work, IRA’s, and life insurance policies all have beneficiary designations that supersede wills. Naming beneficiaries to these types of accounts is one of those planning activities that is typically given too little thought, however those named to inherit such assets often face unique tax and legal consequences.
Employer-Sponsored Retirement Plans and Individual Retirement Accounts (IRAs)
Regarding employer-sponsored plans, such as 401(k)s, an individual who is not married can name whomever they like as beneficiary. If you are married, however, federal law states that your spouse is automatically the beneficiary of a 401(k) or profit-sharing plan. If you wish to name someone else as beneficiary, then your spouse must sign a written waiver.
For example, someone who has been separated from his or her spouse may wish to name a domestic partner as the intended beneficiary. The spouse still has a legal claim to the 401(k) assets, and the domestic partner will not be able to receive the funds unless the spouse signs a written waiver. A waiver may be appropriate in other situations, such as a second marriage in which children from the first marriage need the money more than the new spouse.
Until recently, one drawback was that nonspouse beneficiaries were not eligible for tax-deferred transfers to IRAs. Instead, these beneficiaries would have to begin taking distributions, on which they would be required to pay income tax. However, rules signed into law in 2006 allow nonspousal beneficiaries to have qualified plan proceeds rolled over into a special type of IRA called a “Decedent IRA” set up on behalf of the beneficiary via a trustee-to-trustee transfer.
The IRS has also issued regulations that dramatically simplify the way certain withdrawals affect IRA owners and their beneficiaries. Consult your tax advisor on how these rule changes may affect your situation.
IRS regulations do allow nonspousal beneficiaries to annuitize retirement plan distributions over the life of the beneficiary. Check with your employer or policy issuer to find out if this is an option under your arrangements prior to naming a child as a beneficiary.
Life Insurance
No matter who is designated as beneficiary of a life insurance policy, he or she will receive the death benefit proceeds income tax free. Unlike property disposed of in a will, if the beneficiary designation form is properly completed, insurance proceeds do not go through probate.
For many married people, a spouse will be the most logical beneficiary. A trust may be a better beneficiary choice, however, if a surviving spouse was not capable of (or comfortable with) managing a large sum of money. In this case, the trustee (often a legal entity rather than an individual) would take charge of managing, investing and disbursing the policy proceeds for the benefit of the surviving spouse.
Be sure to name contingent or secondary beneficiaries. A secondary beneficiary — either an individual or trust — would be next in line to inherit the insurance proceeds if the primary beneficiary predeceases the insured. If there are no surviving beneficiaries, then your beneficiary is generally the “estate of the insured,” which means the death benefits end up being probated and ultimately distributed according to the instructions of the decedent’s last will and testament. If an individual dies without a valid will (intestate), then the order of legal beneficiaries to whom assets are distributed is specified by state law.
Avoid Naming Minor Children
Naming minor children as beneficiaries may cause unforeseen problems. For example, insurance companies and retirement accounts may not pay death benefits to minors. Instead, these benefits are held until they can be paid to a court-approved guardian and/or trustee of a children’s trust or until the child reaches legal age. A guardian, trust or trustee should be named beneficiary to ensure competent management of the proceeds for the children. By naming a children’s trust as a beneficiary, the proceeds could be invested and managed by a competent trustee (a person or institution) you choose. A revocable living trust could also be named as a beneficiary, which keeps the proceeds out of probate.
Keep Your Plan Up-to-Date
When completing overall estate plans and wills, it is important to occasionally review and readjust all beneficiary designations so that your estate plan accurately reflects your wishes. Remember, outdated beneficiary designations (e.g., older parents or ex-spouses) could misdirect the intended flow of an entire estate plan unless changed now.
Securities offered through LPL Financial, Member FINRA/SIPC
