Beneficiary Designations – Part 2 (Avoiding Mistakes)
This article is the second in a series about beneficiary designations. Our first article discussed the different types of beneficiary designations and provided basic information in regard to how they operate. This explains common beneficiary designation mistakes and how to avoid them.
Beneficiary Designation Missteps and How to Avoid Them
The following information is generally applicable, however, it’s important to review state law and the specific financial institution’s procedures to determine the treatment of a particular asset, account or fund. Additionally, please note that the below information relates to designations for bank accounts, securities, retirement accounts, life insurance policies and commercial annuities. The remainder of this article does not apply to TOD deeds for real property, which will be covered in a future post.
1. Beneficiary Designation Conflicts with Estate Plan Documents
The owner of a policy, account or fund (hereinafter referred to as “owner” or “client”) must understand that a beneficiary designation supersedes whatever is written in a will or trust. A beneficiary designation form is a contract and, as such, regardless of what a client’s will or trust says, designation forms for retirement accounts, securities, bank accounts, life insurance policies and commercial annuities will control the disposition of the asset at the owner’s death. This is important to understand, as sometimes a client will ask his or her attorney to make changes to a will (or prepare a will) that passes an account or fund to someone other than the designated beneficiary of that account. Regardless of the client’s intent or the timing of the will or trust’s execution, the asset will pass according to the terms of the beneficiary designation.
Many court cases have been based on this conflict between an estate planning document (usually the will) and a beneficiary designation. Even in states where the decedent’s intent can be used to overcome what is stated in estate planning documents, beneficiary designations have usually been held by courts to be binding. By the way, having your name on one of these court cases is not the way you want to become famous.
2. Owner Fails to Update Beneficiary Designation
Perhaps the most common, and often most detrimental, beneficiary designation mistake is failing to update the designation when the owner experiences a change in circumstances. Just like estate planning in general, beneficiary designations should not be approached with a “one and done” attitude. The last thing the owner wants is for an asset to be distributed to individuals whom the owner clearly would not have selected to inherit those assets. The risk of unintended beneficiary distributions increases the longer the owner waits between periodic beneficiary designation form reviews.
Barbara is the owner of an investment portfolio. When Barbara opened the account, she named her fiancé Ted as the transfer on death beneficiary. Barbara and Ted had a significant falling out and ended the engagement. Barbara had her attorney prepare a new will. In the will, Barbara specified that her sister, Anita, would receive Barbara’s investment portfolio upon her death. A few years later, Barbara passed away. Even though Anita was subsequently listed as recipient of the account in Barbara’s will, Ted received the account because the beneficiary designation, not the will, controlled.
It’s important that individuals regularly review their beneficiary designations, especially when circumstances change or important life events take place. Events that require a review and/or update of beneficiary designations and the overall estate plan include:
- birth or adoption of a child or grandchild
- death of a family member or friend
- a child reaching adulthood
- a serious medical diagnosis
- a traumatic event such as incapacitation or perhaps even an estrangement from a close friend or family member
In 1982, John and Lauren were married with one child, Howard. When John landed his dream job in 1985, he designated Lauren as the primary beneficiary and Howard as the contingent beneficiary of his very generous employer-provided retirement plan.
A few years later, Lauren and John had a second child, Lisa. Lauren passed away in 2014. Even though both Howard and Lisa were included in John’s will, John never updated the beneficiary designation form for his retirement plan. At the time of John’s death earlier this year, Howard was the only living named beneficiary of the retirement account, an asset that represented the bulk of John’s estate. Lisa, however, was not named as a beneficiary and so she did not inherit any interest in the retirement account. The effect was that John’s (outdated) plan resulted in an accidental disinheritance of Lisa.
So, keep those beneficiary designations updated. Also, whenever providing new designations to an insurance company, bank, brokerage firm, etc., have them acknowledge in writing that the change has been recorded in their records. Just because you mail, email or even hand the form to someone doesn’t guarantee it’s been changed.
3. Designated Beneficiary Predeceases Owner or is Not Ascertainable
An attractive feature of beneficiary designations is the ability to avoid passing an asset through probate. However, when owners fail to designate contingent beneficiaries or fail to include enough identifying information, they run the risk of passing an asset through probate due to the failure of a beneficiary designation. By not including a contingent beneficiary, there is a risk that the sole designated beneficiary will predecease the account owner, which would force the asset to be transferred to the owner’s probate estate at death. This can be easily avoided by naming other relatives, trusts or charities as contingent beneficiaries.
Another misstep that could create an ineffective beneficiary designation is failure to provide specific identifying information about the beneficiary. If, upon the owner’s death, the beneficiary cannot be identified, then the asset will be transferred to the owner’s probate estate. While it may seem you are being asked to provide a lot of personal info for your beneficiaries, this is a good thing in the long run if it helps properly identify the rightful recipients of your asset.
4. Spousal Issues and Joint Accounts
It is important to be aware that some beneficiary designations may require spousal consent. Due to spousal protection laws, many retirement plans (e.g., 401(k)) require the owner to obtain signed consent from his or her spouse before designating someone other than a spouse as the beneficiary of a retirement account.
For other retirement plans (like IRAs) and POD accounts, the rights of a spouse will usually depend on state law. Also, special rules apply in community property states.
Another issue that sometimes arises involves joint accounts. Where two people hold co-ownership of an account with a right of survivorship, and the owners execute a POD form, the POD form will not be effective at the first death. Instead, all assets in the account will pass to the surviving owner regardless of who was named on the beneficiary designation. This could lead to troublesome results if an owner does not understand the relationship between joint accounts and beneficiary designations.
Richard was settling into retirement and decided to add one of his sons, Allen, as a co-owner of his investment account so that Allen could assist Richard with financial management in later years. The value of the account at the time was over $500,000. A few years later, Richard executed a payable on death document with the financial institution that held his account. He named all three of his sons – Allen, Butch and Chuck – as primary beneficiaries to split his account in equal shares. A few years later Richard passed away.
By adding Allen as a joint owner of Richard’s account, multiple unintended consequences resulted:
- Richard opened his account up to claims from Allen’s creditors
- There are possible gift tax ramifications
- Richard passed all of the remaining account assets to Allen upon his death, not all three sons
The POD form was trumped by the joint ownership rules and was therefore ineffective. If Richard had instead granted a power of attorney to Allen for his investment account assets, he would have received the financial assistance he desired and his account would have been passed on to all three of his children in accordance with his wishes.
5. Solely Using Beneficiary Designations to Distribute Assets
While beneficiary designations can be a powerful component of a comprehensive estate plan, they should not be the only planning tool utilized. Clients still need to create the necessary documents in order to plan for future medical and financial decisions and to designate a guardian for minor children. In addition, a trust might be needed if the client plans to designate minor children or individuals with special needs as beneficiaries (see section six for further discussion).
Also remember that distributing all assets to individuals and/or entities may leave the executor with no funds to pay final expenses and pay off debts. This can create a very uncomfortable position for an executor who is responsible for these expense, and he or she may even have to compel (sue) beneficiaries for needed assets should the beneficiaries fail to cooperate.
6. Designating Minor Child or an Individual with Special Needs as Beneficiary
Proceed with caution before designating a minor child as a beneficiary of a retirement plan, IRA, life insurance policy or POD account. If a minor child inherits such an asset by way of a beneficiary designation, the child will receive the asset in its entirety upon reaching the age of majority (18 or 21 depending on state law). Prior to that age, the court will have to select a guardian/conservator to manage the property on the child’s behalf. This could entail court costs, attorney’s fees and other expenses. Once the child reaches the age of majority, he or she will suddenly be the recipient of a large amount of wealth.
So, instead of naming a child directly as beneficiary, it may be preferable to set up a trust where the trustee can manage the funds and make distributions in accordance with the terms of the trust and the needs of the child. By going this route, the asset can be distributed over a period of time rather than all at once, thereby avoiding potential financial missteps on the part of the child.
Additionally, a beneficiary designation may not be the best planning tool for beneficiaries with special needs. If an individual is receiving needs-based government benefits, such as Medicaid, Supplemental Security Income or Affordable Housing, then designating that individual as a direct beneficiary of an IRA, life insurance policy or bank/investment account could disqualify the individual from receiving those government benefits. An alternative would be to set up a “special needs trust” to leave assets to individuals with special needs. Creating a special needs trust would allow the client to leave assets for the benefit of the special needs individual, choose a trustee to exercise discretion over the funds and provide for the individual’s wellbeing without jeopardizing his or her eligibility to receive government funds.
Tax-Smart Beneficiary Designations
Not all account types, and therefore beneficiary designations, are created equal. Proceeds from bank accounts, life insurance, and even investment accounts usually come to beneficiaries without income tax consequences (there may be estate tax consequences, but that’s beyond the scope of this article). On the other hand, retirement assets such as a 401(k), IRA, pension plan or even the gain portion of tax deferred annuities are taxable to individual beneficiaries. There are at least two things to think about when designating this second (“taxable”) asset type.
First, when leaving a taxable asset to a person, it’s wise to leave it to the person(s) who can defer taxation the longest. This may be a spouse, who can treat the asset as their own in most cases, or it could be a younger child who can stretch the withdrawal of a retirement account over a longer life expectancy and therefore spread the tax.
Second, for those with charitable intent at death, naming a charitable organization as beneficiary of a taxable asset is a great way to erase the tax owed on the asset since the charitable organization will not pay income tax. Other non-taxable assets can be left to individuals. This plan maximizes the after-tax benefits to both charitable and non-charitable beneficiaries.
When used correctly, beneficiary designations can be an effective and useful way to pass on assets to loved ones. By filling out a designation form, bank accounts, securities, retirement funds, annuities and life insurance policies can be transferred without probate to beneficiaries. However, there are many ways that a well-intended designation can cause problems upon the death of the owner. Complications can arise in many instances, including where the designation conflicts with the owner’s estate plan, the owner fails to update the designation form upon a change in life circumstances, the owner does not designate contingent beneficiaries or fails to provide adequate identifying information, the asset is held jointly with a right of survivorship, the asset is community or marital property, the beneficiary is a minor or an individual with special needs or the owner designates his or her estate as beneficiary. These actions can all have unintended and unexpected consequences. As such, it is recommended that individuals work alongside their advisors to ensure that their beneficiary designations successfully carry out their estate planning goals.
Any information presented here is general in nature, believed to be reliable as of the date published and is not intended to be and should not be taken as legal, tax, investment or individual financial planning advice. Competent, licensed professionals should be consulted when implementing any kind of financial, estate, tax or investment strategy.