Most people understand the importance of having a will or trust to dispose of property at death. They carefully consider the options and decisions that must be made in the will or trust and devote much time and energy to making sure their wishes are stated in the documents.
But many people are not as careful concerning beneficiary designations made on life insurance policies, retirement accounts, and other assets. In some cases, they simply do not understand the consequences of the beneficiary designations. In others, they may realize that beneficiary designations should be changed but never take the steps to change them.
There are three common mistakes – each of which can have a huge impact on an estate – when designating a beneficiary.
Mistake No. 1 – Naming an individual as beneficiary of life insurance policies
A life insurance policy is a contract between the policy owner and the insurance provider. The policy owner has the right to name a beneficiary of the policy. When the owner dies, the provider must pay benefits to the named beneficiary according to the rules of the contract, even if the owner’s will or trust says otherwise.
Estate planning in a will or trust often anticipates that life insurance proceeds will be available to pay debts, taxes, and expenses. Estate plans often use insurance proceeds to fund trusts designed to minimize death taxes or manage inheritance for young or disabled beneficiaries. These can be some of the most important aspects of the estate plan.
If the contract requires the life insurance proceeds to be paid directly to an individual as the named beneficiary, then the proceeds do not pass under the will or trust and cannot be used to make the payments or fund the trusts described above. This can effectively undo otherwise careful and good estate planning.
Solution: Consider naming your estate or trust as the beneficiary of your life insurance policies, rather than naming an individual person as the beneficiary.
Mistake No. 2 – Failing to name a beneficiary of retirement accounts
The owner of a retirement account – such as an IRA, 401(k), 403(b), pension or annuity – may name a beneficiary of the account. Often the account is income tax deferred, meaning that the owner of the account does not pay income tax on the earnings from the account until those earnings are actually received at some point in the future.
The account passes to the beneficiary named by the owner when the owner of a retirement account dies. The account passes to the owner’s estate if the beneficiary is not living or no beneficiary has been named by the owner.
When a retirement account passes to an individual as the named beneficiary of the account, the beneficiary is usually permitted to take distributions of the account over time (based on life expectancy) and delay triggering the income tax liability.
But when a retirement account passes to the deceased owner’s estate, the estate is required to cash in the entire account within five years of the owner’s death. The estate must receive all of the earnings from the account within the five years and must pay income tax on all of the earnings.
For those who are charitably minded, naming a charity as the beneficiary of a retirement account can be a great option. So long as the charity has tax-exempt status from the IRS, the charity can receive the entire account at the owner’s death, including the earnings, but will not be required to pay income tax on that property.
Solution: Consider naming an individual or charity as beneficiary of your retirement account rather than naming your estate.
Mistake No. 3 – Naming a minor as beneficiary of any asset
Most people assume that it is best to name a spouse as the primary beneficiary and to name children as contingent beneficiary (so they would receive the asset if the spouse is deceased) when asked to make a beneficiary designation on a life insurance policy, retirement account, or other account. This is fine in some cases. But what if any of the children are minors?
I tell clients never to name a minor as the direct beneficiary of any asset. This act may be well-intentioned, but it can wreak havoc on the estate plan.
If a named beneficiary is a minor, the property cannot be paid directly to the beneficiary. Instead, someone must petition the court to be appointed as legal guardian for the minor so that the distribution can be made to the guardian instead. From that point forward, the court supervises the guardian’s handling of the minor’s property. All of this involves extra time, trouble, and expense that could have been avoided.
Possibly the most troubling consequence is that the beneficiary’s guardianship ends when the beneficiary is age 18 rather than the age selected by the deceased owner in the owner’s will or trust. Whatever property is left in the guardianship is distributed to the beneficiary with no supervision or strings attached. This creates a perfect storm for financial disaster – 18 year old, sudden distribution of property all at one time, no restrictions – which the parent never intended.
Solution: Consider providing for the minor in your will or trust and naming your estate or trust as the beneficiary, rather than naming the minor as a direct beneficiary.
Recommendations
There is no single solution for estate planning. Each situation is unique and requires special attention.
Consult with an estate planning attorney about your beneficiary designations. Understand the effect of the designations you have made and consider the pros and cons of other options. Then, make a decision about whether changes are needed and take the steps to carry out that decision.
Making a new beneficiary designation can be as simple as completing and submitting a short form. It is just not worth it to ignore this important aspect of your estate plan when you consider the little effort that is required to update your beneficiary designations compared to the potential consequences of not updating them.
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Bad Beneficiary Designations Can Undo Good Estate Planning