If you ask most people, they would say they understand the importance of having a Last Will and Testament or a Revocable Living Trust to distribute property according to their wishes at their death. For many, however, the estate planning stops there…with potentially disastrous consequences. Careful attention must be paid to beneficiary designations on matters such as retirement accounts, life insurance policies, certificates of deposit, and any other asset that passes by virtue of the owner selecting a recipient. In some situations, however, clients don’t understand the consequences of their beneficiary designations and how those designations relate to the distribution of their assets. In other instances, they never take the initiative to make necessary changes.
There are several common missteps when it comes to beneficiary designations and each can negatively impact an estate plan. Here are two of the most pervasive:
Naming an Individual as Beneficiary of a Life Insurance Policy
A life insurance payout is governed by the contract (i.e., the beneficiary designation). This means if the beneficiary designation lists an individual as the beneficiary, the life insurance proceeds pass outside of the insured person’s will or trust, even if the will or trust distributes property differently than the beneficiary designation. Take this example: John and Jane are married. John purchases a $1 million life insurance policy in 1980. John names his wife, Jane, as the beneficiary of this policy. John and Jane divorce in 2005 and a divorce decree provides that neither former spouse is obligated to the other under their estate plan. John gets remarried to Betty in 2007 and has a new will prepared leaving his estate to Betty. John dies in 2011 having never changed his life insurance beneficiary designation on the life policy. Who gets the life insurance? Jane, the first wife, gets the proceeds to the exclusion of Betty! The divorce decree had no effect over the designation.
To prevent a scenario such as this, it’s important to make sure all beneficiary designations name the person or institution that you currently want to receive the death benefit. Keep a list at home or in a safe place that tells how your most recent beneficiary designations are listed. Review the list once a year or when there’s a major life change (marriage, divorce, birth of children, death of beneficiary, etc.) and make changes as necessary.
Another potential problem with naming an individual as the beneficiary is that, oftentimes, clients will apply for a life insurance policy so the death benefit will be available to pay their taxes, debts and/or expenses. It’s common for estate planning professionals to recommend that life insurance proceeds be used to fund trusts established to achieve those goals. However, if the beneficiary designation names an individual, the proceeds don’t pass under a will or trust and cannot be used to pay taxes, debts or expenses, or to fund the trusts described above. In addition, the designation could disqualify disabled persons from their governmental assistance programs, such as Medicaid. The solution? If you intend for your life insurance to satisfy your obligations, consider naming your estate or a trust as the beneficiary of your life insurance policies, rather than naming an individual person. By doing so, you ensure the death benefit will go to satisfy your debts, taxes and expenses, if that’s your goal. If your objective, on the other hand, is to care for a minor child or disabled person, consider naming an appropriately drafted trust to meet the needs of those individuals through a trust vehicle.
Retirement Account Beneficiaries
Similar to life insurance policies, those of us who have retirement accounts (IRAs, 401(k), 403(b), pensions, etc.) can choose where the funds will go when we pass away by completing a beneficiary designation form. If the named beneficiary has predeceased or no beneficiary has been named, most retirement accounts pass to the account owner’s estate.
Unfortunately, because of the income tax-deferred status of some retirement accounts, the naming of a beneficiary—or the failure to do so—can have tax consequences for person/persons or entity that receives the remaining proceeds. The designated beneficiary of a retirement account is determined at the end of the year following the year of the account owner’s death, allowing you to change beneficiaries easily. Funds left in a retirement account, such as an IRA, after its owner dies must be paid out within a certain period of time. These post-death payout rules have been simplified and liberalized as follows:
• If a retirement account has a designated beneficiary, the account balance may be paid out over the beneficiary’s remaining life expectancy. In general, a designated beneficiary must be an individual, such as your child, and can’t be an institution or your estate.
• If the retirement account does not have a designated beneficiary and the account owner dies after his required beginning date, the account balance may be paid out over the remaining life expectancy of the account owner, determined just before he died.
• If the retirement account does not have a designated beneficiary and the account owner dies before his required beginning date, the account balance must be paid out within five years after the owner’s death.
Additionally, many people believe if they fail to change a beneficiary designation on a retirement plan that their estate plan (i.e., will or trust) will control. This is false, however, and could result in disastrous consequences. The 2009 United States Supreme Court case, Kennedy v. Plan Administrator for DuPont, ruled that the retirement account for a deceased man be distributed to his ex-wife rather than his estate even though there was a divorce decree severing all ties between Mr. Kennedy and his ex-wife. The Supreme Court held that the beneficiary designation controlled above all else. While this result clearly wasn’t what the decedent would have wanted, his estate plan was somewhat disrupted because he failed to change the form. To avoid repeating Mr. Kennedy’s mistake, check your retirement plan beneficiary designations to ensure (a) there is a designated beneficiary and (b) the beneficiary still meets your current desires.
There are other issues related to beneficiary designations not covered in this article. Every person’s situation is slightly different, requiring analysis and discussion to find the right solution. Estate planning attorneys are equipped to walk you through the pros and cons of what you’d like to do, how best to achieve it, and how your designations can complement the plan you put in place. This exercise will shed light on whether or not you need to make changes to your beneficiary designations. Most times, changing the designation is a simple process—requesting, completing and returning a new designation form.
As described above, ignoring your beneficiary designations can derail an otherwise well-designed estate plan. Therefore, consider the consequences and determine if you need the assistance of an estate planning professional to help ensure your plan is flawless.
This article was written by:
Cleve Hill, Esq. & Caroline Vann, Esq.
BETTIS, HILL & VANN, LLC