One of the most impactful decisions you can make in your estate plan is designating a beneficiary for your qualified retirement accounts, life insurance policy, bank accounts, etc. An oversight with a beneficiary designation can be an extremely expensive mistake that results in the wrong person receiving your hard-earned assets after your death and effectively wreck your estate plan.
Many people are surprised to learn that a trust or will does not actually control who will receive all of their assets when they pass away. Some major assets possessing tremendous value actually transfer from a decedent via beneficiary designation. This is one of the most powerful and often overlooked aspects of estate planning. A beneficiary designation is powerful because it effectively trumps other estate documents if a conflict arises concerning who receives which asset.
What exactly is a beneficiary designation?
A beneficiary designation is the act of selecting an individual(s) or organization(s) to inherit an asset upon your death. Beneficiary designations are typically used for financial accounts, life insurance and qualified retirement accounts. Designated beneficiaries are typically a spouse, child or other relative, but they also can be a trust or charitable organization.
One of the key benefits of a beneficiary designation is that it is simple and to the point. There is typically no argument about the account owner's state of mind, whether there is a handwritten modification buried in the backyard, or other issues commonly raised with wills. The name on the beneficiary designation form receives the assets in the account. Nevertheless, beneficiary designations also can create many serious and expensive problems. Here are five of the most common pitfalls associated with beneficiary designations:
- Failing to actually name a designated beneficiary
- Failing to list a contingent beneficiary
- Failing to update your designated beneficiaries regularly
- Selecting your trust as a designated beneficiary for your retirement accounts
- Failing to review beneficiary designations with skilled and experienced advisers
Let's take an in-depth look at each pitfall and what you can do to avoid them.
Pitfall No. 1 - Failing to actually name a designated beneficiary
It may be due to apathy, procrastination or a simple oversight, but many people actually never designate a beneficiary for their life insurance policy, individual retirement account, bank account, etc., which exposes these valuable accounts to the costly and inefficient probate process. Failing to designate a beneficiary means you are giving a financial institution the power to decide where your account assets go after you pass away. This is because many financial institutions have their own set of rules and regulations for the transfer of account assets where no beneficiary has been designated. For example, a life insurance policy lacking a designated beneficiary means the proceeds are typically paid out to your probate estate.
For a retirement account like a 401(k), your spouse will most likely receive the account assets (assuming you are married). If you are not married or your spouse predeceased you, then the retirement account will likely be paid to your probate estate. This can trigger a significant tax event since the assets in your retirement account must be paid out within five years of your death. This can cause an acceleration of the deferred income tax, which must be paid earlier than would have otherwise been necessary, explains Kiplinger's Tracy Craig.
Pitfall No. 2 - Failing to list a contingent beneficiary
Effective estate planning entails the contemplation and preparation for a variety of different future events. This is why it is important to include a contingency beneficiary along with a designated beneficiary. Why? Because if the primary designated beneficiary predeceases you and there is no contingent beneficiary listed, the account assets will likely go through probate. In addition, when you name a contingent beneficiary, you are giving the primary beneficiary the flexibility to decide whether to claim the account assets or to decline the assets, which may be warranted for tax implications or other considerations.
Pitfall No. 3 - Failing to update your designated beneficiaries regularly
Updating your designated beneficiaries is extremely important to ensure the right people receive your hard-earned account assets. Failing to regularly review and update your beneficiaries creates the risk that someone you no longer care for winds up receiving your valuable life insurance policy or retirement account. One of the most common examples is an account owner who named their spouse as the designated beneficiary, then got divorced. The account owner failed to update the designated beneficiary form and upon their passing, and the ex-spouse received the account assets.
Pitfall No. 4 - Selecting your trust as a designated beneficiary for your retirement accounts
On the surface, this seems like a nifty estate planning technique. In reality, it is an expensive mistake. Why? Because the proceeds of qualified account (an IRA, 401(k), etc.) are required to be distributed to a designated living person with a lifespan, rather than an entity, in order to maintain the account's tax-advantaged status. Generally, a trust will not qualify for pass-through tax treatment unless all trust beneficiaries are individuals. If a trust fails to meet the standard for pass-through treatment, the funds in the account will be distributed and taxed over a maximum of five years, leading to a massive loss of tax savings.
Pitfall No. 5 - Failing to review beneficiary designations with skilled and experienced advisers
Deciding who to designate as an account beneficiary carries significant implications for other aspects of your estate plan, which is why it is important to sit down with experienced professionals to discuss who to designate and the proper procedure for making the designation.
For example, if you attempt to fill out the beneficiary designation form by yourself, you run the risk of filling it out incorrectly. There could be multiple individuals in your family with similar names. For example, there could be a John Smith Sr. and John Smith Jr., but the beneficiary designation form only lists "John Smith." Not having names match exactly can result in significant delays in payouts, and when two people have similar names, it could result in the individuals attempting to resolve the dispute through costly litigation.
Another issue that warrants advisement by a professional is designating a minor as a beneficiary. Because children are considered to not be legally competent until they reach the age of 18, they will not be able to claim the account assets. This means there will need to be a court-appointed conservator to manage the account funds until the minor reaches the age of 18.