The use of beneficiary designations is one issue that is not well understood and can lead to much confusion.

Most people think it is a simple matter of naming a person to receive certain assets by will or trust or naming them as a beneficiary of a retirement plan. I only wish it were that simple!

There are many challenges to having the correct beneficiary to accomplish what you actually intended for the property being transferred. Some of these challenges can have significant income tax consequences, incurring higher cost to transfer and creating emotional family issues if there are multiple beneficiaries.

 
 

Here are six examples for setting up proper beneficiaries.

Wills

The majority of people have a will and believe that the will takes care of the distribution of all of their assets to the surviving beneficiaries. In simplest terms that may be true. However, beyond naming your spouse as a beneficiary, and then naming children as contingent beneficiaries (per stirpes or per capita), how do you determine the amount of financial assets vs the personal assets to gift, name other family beneficiaries and possibly gift to charitable organizations?

In addition, each state may have requirements as to what must be included in the document to have a valid will. The key questions are; what is the ultimate disposition of your assets and how important is it to leave a legacy to your family?

My suggestion is to be careful when determining the amount of financial assets to leave a beneficiary. Leaving specific amounts may create a problem if assets have been spent for continuing care or end of life care. It may be better to leave percentages rather than a specified amount.

For personal property, it may be a good idea to identify the beneficiary of each major item to prevent squabbling among siblings! Having a letter of instruction identifying who gets certain jewelry, art, antiques or other personal item that may have special meaning to one child or another can go a long way to maintaining peace in the family.

Revocable Living Trust

Revocable living trust documents are a common way for families to pass down assets while avoiding probate costs. However, in my opinion, they play an even more important role in that they can allow the successor trustee to manage the affairs of an individual in the event of incapacity.

The trust may also be a good way to manage holding assets in different jurisdictions, such as owning a second home in another state. The beneficiaries in a trust are usually very much the same as in a will. In fact, once the children are no longer minors, a will may not be necessary at all if a properly drafted trust is in place.

Transfer on Death (TOD)

A simple way to directly transfer financial assets to a beneficiary is to use a TOD registration for an account. In this way, you will avoid probate and allow the asset to pass without delay. However, it does not provide any benefit until death!

Retirement Accounts Such as IRAs and 401(k)s

Retirement accounts are special in that they are actually already in a retirement trust and a beneficiary may receive benefits without going through probate. That is why, in most cases, I do not recommend that the beneficiary of a retirement account be named in a will. Naming living beneficiaries of an IRA has additional benefits, namely the ability to “stretch” out payments over the life of the beneficiary rather than receive a lump sum benefit.

Because retirement accounts are fully taxable to the recipient (except Roth IRA), the tax burden would then be spread out over the beneficiary’s life time. You can have multiple beneficiaries of one IRA or set up multiple IRA accounts naming different beneficiaries. Having multiple accounts allows each beneficiary to maximize the stretch portion of the distributions based upon their life expectancy. If one IRA has multiple beneficiaries, the oldest age is used for all beneficiaries when determining the life expectancy.

A special note for those IRA owners over age 70: you can make direct gifts of IRA monies to charitable organizations and have it count towards the Required Minimum Distribution (RMD) each year. This also saves having the RMD increase income on your tax return that would affect future Medicare premiums.

Life Insurance Policies

Normally life insurance is purchased to provide capital to the surviving family members to ensure their ability to maintain their standard of living. If you are retired, the need for life insurance may be reduced or eliminated unless there is a continuing need for protecting the surviving family.

If the life insurance is owned by an individual, then the death benefit would be included in the estate of the insured. However, if the life insurance is owned by an irrevocable trust, the death benefits are paid to the trust and are excluded from the estate of the insured. This was a bigger issue prior to the expansion of the allowable credits that eliminated estate taxes for families with assets under $10 million.

The note here is that upon divorce or upon the death of a beneficiary, the beneficiary designation needs to be reviewed and changed if appropriate under the circumstances.

Annuities

Annuities can be a full discussion by itself! If you own an annuity – regardless of the type – you should ask your advisor to fully explain the beneficiary situation including the contingent beneficiary, and the difference between the owner, annuitant and beneficiary in the contract. It can make a very big difference regarding taxes and the ability to do what the contract was intended to do. The wrong selection can have a dramatic impact on the actual benefits obtained from an annuity.

When was the last time you reviewed your beneficiary designations and read your will and trust documents? If it has been more than 5 years you should take another look and be sure that they reflect what your intentions are at this time in your life.

Other documents to review at the same time would be medical directives and powers of attorney as these may be out of date and no longer accepted. They typically have about a 5-year shelf life so be sure to keep them up to date as you will not be able to do so at the time of need!

What steps have you taken to manage your beneficiary designations? How have letters of instruction helped keep the peace in your family? What other documents have you prepared ahead of need? Please join in the conversation.

Note! An estate tax attorney should be consulted to properly draft estate planning documents.

Stan CoreyStan Corey is a CFP, ChFC and CPWA providing financial life management for more than 36 years. Stan has published a novel, The Divorce Dance, which is a story about a divorcing couple whereby the wife, Natalie, guides the reader though the divorce process and how to have a respectful divorce. Please visit his website.

Let's Have a Conversation!