FOR RETIREMENT PLANS AND LIFE INSURANCE
TRUTH OR CONSEQUENCES—PLAN OR (MAYBE) HAVE YOUR PLAN FAIL
While your will is central to your estate planning, for most people, it’s not the entire story. You probably have assets that pass directly to a beneficiary or a survivor upon the owner’s death. These assets are usually not controlled by your will (or revocable trust, if that is what you are using as your primary planning instrument). These non-will assets can include property and bank accounts held in joint tenancy with right of survivorship, accounts with pay on death provisions, life insurance policies, and retirement accounts. For many, their life insurance and retirement accounts constitute a very significant portion of their wealth, but these assets seldom get the same level of attention that is given to the provisions of their wills.
Let’s talk about the estate planning issues relating to the beneficiary designations for your life insurance policies and retirement accounts (e.g. IRAs, 401(k)s) and make sure you don’t fall into the trap of having your well-thought-out estate plan fail because you did not coordinate how these assets pass with your overall plan.
What Are The Pitfalls? The actual process for designating beneficiaries is fairly simple. You get a beneficiary designation form from your insurance or investment company, fill in your primary beneficiary, your contingent beneficiary, and return the form to the company. Easy. Done.
While the process is simple, failure to carefully consider how these designations should be completed can have a number of unintended consequences. Here is a list of some common issues:
Naming your estate as your beneficiary
Possible Consequence: This can have a bad tax impact and your credit or shave access to the funds where they otherwise would not.
Possible Solution: Name an individual, a trust under your will, or a trust you have already established (care in naming a trust as a beneficiary of retirement plans is critical!).
Note: If you do not have a valid beneficiary designation on file with a company, your estate is often their default beneficiary.
Naming a minor child, a disabled person, or someone who can’t handle money as a direct beneficiary
- Minor Child: Unless the company has a method to deal with funds
passing to a minor, court action may be required (e.g. a guardianship or court-supervised trust) and the child gets all of money (or, at least, control over the money) at age 18.
- Disabled Person: Receiving the funds may disqualify the beneficiary from receiving public assistance that could otherwise be available.
- Bad-With-Money Person: He or she can get all of the money right away; if there is a bankruptcy or that person is vulnerable to financial exploitation, the money would go for others, not the beneficiary.
Possible Solution: Name a trust for that person under your will (or a sub-trust under your revocable trust, if you are using that as your primary planning instrument). You choose when and how the beneficiary gets the money, and a special needs trust for a person with a disability preserves his or her eligibility for government assistance.
Note: Creating and naming a trust for retirement benefits is technical, do it wrong and certain very substantial tax benefits could be foreclosed—this is not “do it yourself” friendly! Contact a qualified attorney or tax advisor!
Naming multiple beneficiaries
Possible Consequence: Most companies allow multiple primary or contingent beneficiaries (e.g., “to my children in equal shares”), but if one dies, it is likely that the survivors get that share, even if the predeceased beneficiary has children. That may not be what you would have wanted to happen.
Possible Solution: Specify whether shares are “per stirpes” or “per capita”
▪ Per Stirpes (or “by right of representation”) means that a person’s share is divided among their descendants. If you have two children, a son and a daughter, both of whom have children, and you name your son and daughter equal beneficiaries, per stirpes, if your son
predeceases you, his share will be divided among his children.
▪ Per Capita means that the proceeds are divided equally among the survivors of the people you specifically name. If you name your children in equal shares, per capita, and your son dies, your daughter gets everything.
Note: If you do not specify, most companies use per capita as the default.
Tax Implications for Your Beneficiaries
Possible Consequence: The beauty of most retirement plans is the tax deferral—you don’t have to include the plan assets in your income until you take distributions, and those can be stretched out over a long period of time. Generally, the tax-deferred feature of these plans can continue for your beneficiaries; however, who you name, and how you name them, can greatly affect how much income tax your beneficiaries pay, and when they have to pay that tax. Do it wrong and you may be foreclosing or limiting the opportunity for tax deferral for your beneficiaries.
Possible Solution: Structure your beneficiary designations to minimize the taxes paid by your beneficiaries. Again, the advice of a qualified attorney or tax advisor is pretty much essential.
Here is a fairly-common case scenario illustrating how the process can give you a result you do not want or intend:
Bob and Joan are married and have two children. Bob’s beneficiary designation for his $1 million life insurance policy names Joan as the primary beneficiary, and then their children in equal shares.
1. Bob dies, survived by Joan and the children. Joan gets the life insurance funds to help her raise the family and to support herself. Everything works out as intended.
2. Bob and Joan die, survived by the two children who are still minors. As minors, the children cannot receive the funds directly, so a court must establish guardianships or trusts for them (this is in addition to the guardianships that will be established for the physical custody of the children). Once a child turns 18, the child receives his or her share of the $1 million policy. Fast cars, exotic vacations, and numerous bad choices follow shortly thereafter.
3. Bob and Joan die, survived by the two children, ages 20 and 18. Skip guardianship, go directly to Porsches and month-long trips to Cancun.
4. Bob and Joan die, leaving adult children in their 40s. Assuming the children are financially responsible and have stable marriages, everything works out as intended.
5. Bob and Joan die. Their adult daughter survives them, but their son has died, leaving children. Bob’s beneficiary designation just indicated “to the children in equal shares” with no instructions about what to do if a beneficiary dies. The company’s default is per capita, so Bob and Joan’s daughter gets everything, and her brother’s children get nothing.
Updating Your Beneficiary Designations
Hopefully, this information will help you to understand the importance of beneficiary designations to your overall estate plan. It is easy to have a false sense of accomplishment once your will/revocable trust is signed. However, unless your beneficiary designations have been reviewed, and, if necessary, changed to complement—rather than frustrate—your estate planning goals, you do not have a complete estate plan. As part of the preparation of your estate planning documents, at Three60 Law Group we review your beneficiary designations and help you, if necessary, to make sure they coordinate with your overall estate planning.
Disclaimers: This material is for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem. Use of and access to this material does not create an attorney-client relationship. The opinions expressed here are the opinions of the individual author and may not reflect the opinion of the firm or any other individual attorney. Any tax advice contained in this communication is not intended to be used, and cannot be used, by any taxpayer for the purpose of avoiding tax penalties.