January 2014

QUARTERLY INSIGHTS FOR CLIENTS: New Year’s Resolution: Check Beneficiary Designations


Instead of just resolving to lose weight or get more exercise in 2014, why not check and update your beneficiary designations?  Chances are that you may uncover old forms that could cause family or tax problems in the future if not corrected.

Beneficiary Designations Control Who Receives Certain Assets

What are “beneficiary designations?”  In estate planning, this means individuals, trusts, or charities listed on beneficiary designation forms as the “beneficiaries” entitled by virtue of these forms to receive assets and benefits passing on death.  Assets paid at death based on beneficiary designation forms include:

  • proceeds of life insurance policies,
  • IRAs,
  • 401(k), pension, profit-sharing, and other retirement plans,
  • deferred compensation plans,
  • annuity contracts, and
  • stock option plans.

Such assets are not paid following your death to those named in your will and revocable trust.  For example, if there is a life insurance policy on you, the life insurance company will not care about who you named as beneficiaries in your will or revocable trust.  Instead, the life insurance company will pay the policy proceeds to the beneficiaries you named on the company’s beneficiary designation form it has on file.

Beneficiary Designations Inconsistent With Will and Revocable Trust

You may forget or fail to appreciate that your will and revocable trust do not cover what might be a large part of your estate – all those assets controlled by beneficiary designation forms.  This can cause problems if those designations are inconsistent with the estate plan set out in your will and revocable trust.  It can become critical for individuals with a significant part of their net worth in such assets.  Those individuals include executives and professionals participating in generous employee benefit or executive compensation arrangements, or individuals with large life insurance policies.

How can such inconsistencies arise?  You may have filled out a beneficiary designation form years ago when opening an IRA or buying a life insurance policy.  The form would have been based on your family and finances at the time.  The form may have been filed with the IRA provider or life insurance company, and forgotten.  Years later, the IRA might be large, the life insurance policy may still be in force, and you may have new children and grandchildren, greater wealth, or even a new spouse.  Even if you are current on who you named to receive your estate under your will and revocable trust, it is all too easy to forget who you named in those beneficiary designation forms so long ago.

The Wrong Beneficiaries Might Receive Payments

This sets the stage for payments to beneficiaries under old forms that have become stale.  Examples include payments to parents named when an insurance policy was acquired by a young person fresh out of college or serving in the military.  Years later, the insured may be married and have a family.  Even if the parents are still living, they may no longer be the right beneficiaries.  A more sensitive problem may be where someone named a prior spouse as beneficiary of a life insurance policy, forgot about it, and then remarried.  If the insured later dies without changing the old beneficiary designation, the former spouse would receive the life insurance proceeds, not the current spouse.

Problems like these can also arise if you complete new beneficiary designation forms without input from your estate planning lawyer.  You likely carefully coordinated your estate planning documents with your beneficiary designations when you did your estate plan with your attorney.  However, if you later opened new accounts or acquired new assets that require beneficiary designation forms, you may not have checked with your lawyer when completing them.  New life insurance policies, annuities, IRAs, and employee benefit plans can present this problem.  Also, if your business or employer changes the administrator of its retirement plans, you may need to complete new beneficiary designation forms provided by the new administrator.  Sometimes pre-printed generic forms are used, containing limited beneficiary choices to be made just by checking boxes.  Such forms may not explain the consequences of making these choices, and the plan administrator’s representatives may lack adequate training about tax traps, or the necessity of coordinating with your existing estate plan and checking with your estate planning attorney.

Tax Challenges

IRAs, 401(k) plans, and other tax-deferred retirement plans present an additional set of challenges.  In general, the longer assets are held in these plans, the better, as tax-deferred investment growth can continue.  Once assets are distributed, they are taxed at unfavorable ordinary income tax rates (with exceptions for Roth IRAs and plans where any income tax basis has been created).

Individuals can be surprised at tax rules that can force some named beneficiaries to take distributions faster than others.  For example, if you named your estate or revocable trust as beneficiary of such tax-deferred plans, all the assets must be distributed within five years after your death, all subject to ordinary income tax.  If instead you named individuals as beneficiaries, you could spread the distributions over their life expectancies.  This allows the assets to continue to grow tax-deferred, the income tax cost on distributions to be spread over many years, and each beneficiary to receive higher after-tax distributions.  You can achieve the same results if you wish to leave such tax-deferred assets in trusts for your children rather than directly to them.  Special “conduit trust” provisions for your children can be added to your revocable trust, which avoid the five-year distribution rule and spread out the payments received by your children over their life expectancies.

If you plan to leave part of your estate to charity (educational institutions, religious organizations, foundations, etc.), a proper beneficiary designation allows you to avoid income tax on payments from IRAs, 401(k) plans, and other tax-deferred accounts.  The concept is simple:  name your charities as beneficiaries of your IRAs, 401(k) plans, and the like.  Leave the rest of your estate to your family and any other non-charitable beneficiaries.  When the tax-deferred assets are distributed to your charitable beneficiaries there will be no income tax due, since the charities are tax-exempt organizations.  You can thus meet your charitable goals and prevent income tax from depleting these assets.

Different considerations should be weighed when naming your spouse as beneficiary of such tax-deferred plans.  Note that the tax rules are designed to encourage naming your spouse.  For example, if you leave an IRA to your spouse, he or she has several ways to treat the IRA as his or her own for income tax purposes.  By doing so, your spouse can defer distributions and income tax for as long as possible under the tax laws: delaying required annual minimum distributions until after age 70 ½ and spreading them out over his or her lifetime.  Also, the new estate tax “portability” rules apply to assets left directly to a spouse.  Portability can allow some married couples to simplify their estate plans by eliminating a trust for the surviving spouse without sacrificing estate tax savings, if other issues do not require keeping the trust.

However, if instead you want to protect your estate from your spouse’s creditors, or from a new spouse and his or her children in the event your surviving spouse remarries, your estate plan should leave your estate in a trust for your spouse rather than directly to him or her.  To obtain the same protection for your IRA without losing the tax advantages just described, you will need a trust designed to:

  • meet the IRA required minimum distribution rules,
  • stretch payments out over your spouse’s lifetime,
  • avoid estate tax in your estate on your IRA, and
  • produce the same estate tax savings available under the portability rules.

A more restrictive rule applies to employer sponsored “tax-qualified” plans such as 401(k), pension, and profit-sharing plans.  It requires that if you are married, you must name your spouse (not a trust or other individual) as beneficiary.  Naming any other beneficiary requires a special spousal waiver under federal law.  If you want to name a trust as beneficiary of such a plan to control the assets following death, your spouse will need to provide the spousal waiver.  If you simply name a trust, your children, a charity, or any other beneficiary without the waiver, your beneficiary designation will be invalid and your surviving spouse can claim the assets.

In Conclusion

It is rare to find someone who does not have some assets controlled by beneficiary designations.  This is not surprising given the prevalence of life insurance, IRAs, and tax-qualified retirement plans.  This means that the task of keeping beneficiary designations up to date is one shared by nearly everyone.  If you decide to make and achieve the New Year’s resolution we suggest, not only will you feel productive, but your family and other beneficiaries may well thank you some day for attending to these details.

This publication is for informational purposes only and is not intended to provide legal or tax advice, or to create an attorney-client relationship.

Pursuant to IRS Circular 230, unless expressly stated to the contrary, any tax advice is not intended and cannot be used to (i) avoid penalties under the Internal Revenue Code or (ii) promote, market or recommend any transaction or matter to another party.