Jul 01, 2020

More Beneficiary Designation Pitfalls

In a recent article, we talked about the dangers of drawing up a will without updating your beneficiary designations. In this article, we’ll continue the discussion around beneficiary designations, focusing on additional pitfalls for those who have young children.

What Are Beneficiary Designations?

Much like a will, beneficiary designations allow you to assign people to inherit your assets upon your death. They are designed to transfer the assets outside of probate, potentially expediting the transfer of funds to the intended beneficiaries while minimizing the costs and publicity of probate. There are many opportunities when you might be asked to fill out beneficiary designations – a few are listed in the chart above.

Beneficiary designations will ask for the names, Social Security numbers, address and contact information of all beneficiaries. It is wise to provide as much of this as possible for the quick identification of the correct beneficiaries and transfer of assets.

Types and Components of Beneficiary Designations

Beneficiary designations typically have two types of beneficiaries listed: primary and contingent. The primary beneficiary is the person you want the funds, or a portion of the funds, to end up with. You can name multiple primary beneficiaries, as long as the percentage assigned to each adds up to 100%. Contingent beneficiaries are the secondary beneficiaries if the primary beneficiaries are deceased or choose to disclaim the assets. Beneficiary designations can be an unending combination of primary and contingent beneficiaries, but a typical setup for an IRA would be a spouse as a primary beneficiary, with the children listed as contingent beneficiaries should there be a simultaneous death or a designation that was not updated after the death of a spouse.

Under a traditional beneficiary designation, the account will only be split among surviving beneficiaries. A per stirpes beneficiary designation, on the other hand, allows the account owner to pass assets to the heirs of the beneficiaries should an original beneficiary predecease the account owner. As an example, imagine a widowed account owner has three children, each with a family of their own, listed as equal beneficiaries. With a traditional beneficiary designation, if one of the beneficiaries dies before the account owner, the two survivors would each receive half of the assets. If the account owner instead assigned the beneficiary designation as per stirpes, the heirs of the deceased beneficiary would receive one-third of the inheritance.

Common Pitfalls for Beneficiary Designations

As we discussed in our previous article, many people fail to realize that beneficiary designations supersede a will and thus can immediately dismantle an estate plan. For example, imagine there is an estate plan consisting of series of trusts outlined in the deceased’s will. If the assets designated to fund the trusts had an erroneous TOD designation applied, the funds would transfer via TOD – and the estate plan would remain unfunded.

This isn’t the only beneficiary designation danger to watch out for, however, especially for those with children:

 

    • Naming a minor child as beneficiary can complicate an estate plan. By law, a minor child cannot inherit an IRA outright – they would need to have a custodian named to manage the assets for them until they turn either 18 or 21, depending on their state of residence. If a custodian is not named in the estate plan or is unable to serve, then the court would need to appoint a custodian, which can be an expensive and lengthy process. Appointing a custodian yourself or setting up a trust to be the beneficiary are options to consider for minor beneficiaries.
    • Overusing beneficiary designations can cause issues for an estate executor, especially when the estate has several beneficiaries. If most of the assets have been disbursed before probate via beneficiary designation, the estate could be underfunded for final expenses, taxes or additional bequests outlined in the will.
    • Using beneficiary designations with a life insurance policy can be especially challenging if you want to keep the proceeds out of the estate and tax-free. A policyowner who leaves a life insurance contract to their estate will increase the size of the estate (and potentially the estate tax bill). There is also the life insurance contract’s “unholy trinity,” where the owner, insured and beneficiary are all different people, potentially making the proceeds subject to gift taxes. For example, imagine Spouse 1 owns a contract on Spouse 2’s life and listed the couple’s child as the beneficiary. When Spouse 2 dies, the death benefit could be considered a gift to the child from Spouse 1 since they were the owner of the contract. Depending on the amount of the death benefit, Spouse 1 could be subject to gift taxes.
    • As a reminder, it is crucial to review beneficiary designations periodically – especially after such life events as a divorce or the death of a beneficiary or spouse. We have heard horror stories where significant sums of money were transferred to an ex-spouse decades after the divorce because a beneficiary designation was never updated.

The pitfalls discussed above are just a few of the many circumstances where things could go far differently than intended. That’s why it’s so important to ensure your financial planner, attorney and CPA are on the same page when it comes to your estate plan. The Baird Retirement Management team frequently coordinates with our clients’ outside representatives to ensure all of our plans are working together, with no gaps or redundancies.

The Pfeil Leatherwood Group is part of Baird Retirement Management, a team of Baird Financial Advisors dedicated to helping our clients plan for and experience retirement on their terms. If you have questions about how you can best plan for your own retirement, we’d love to hear from you!

 

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