Benefiting Your Beneficiaries
By Lori Booth-Houle, CPA, CFP®
Imagine an alternate universe, in which Fred Flintstone is divorced from his first wife Wilma and then remarries. He dutifully updates his revocable trust document to allocate a portion of his estate to Pebbles, his daughter from his marriage to Wilma. The remainder of his estate, including his retirement accounts, goes to his second wife, Ann-Margrock. However, Fred forgets to update the beneficiary designation on his IRA account, which names Wilma as beneficiary. A few years later, Fred has an unfortunate and fatal crane-operating incident at the Slate Rock and Gravel Company. Here’s the question: His trust document clearly states that his retirement accounts go to Ann-Margrock, but the IRA account itself shows Wilma as the primary beneficiary. Who gets Fred’s IRA?
Wilma can laugh all the way to the First National Bank of Bedrock, because she will get the IRA, even though that clearly wasn’t Fred’s intention. A good estate attorney would have talked with Fred about beneficiary designations when he was updating his estate plan, but it was ultimately on Fred to make sure his beneficiary designations matched his current circumstances and his estate documents.
As Fred’s cautionary tale suggests, beneficiary designations on accounts are not a “set ‘em and forget ‘em” type of item in your estate plan. In fact, the best laid plans can be derailed by careless beneficiary designations, or a lack thereof.
A variety of individually-owned accounts and assets provide for designated beneficiaries—the most common are IRAs, employer-sponsored retirement plans, health savings accounts, life insurance and annuities, certain types of brokerage (TOD or “transfer on death”) and bank (POD or “payable on death”) accounts, and in some cases, even homes and cars. One of the key benefits to naming a beneficiary on an asset is that it will pass directly at your death to the beneficiary, with no need for probate (unless the primary beneficiary has predeceased you and there is no living contingent beneficiary).
Here’s the issue, though: Typically, at the time we’re assigning a beneficiary on one of these assets, the main focus is on something else—opening that IRA, or buying that life insurance policy. So we may not give the beneficiary designation on an account a lot of thought, even though, in most cases, this designation will supersede whatever is laid out in your will or trust. And, we tend not to keep these designations up to date with the changes going on in our lives and/or in our estate documents.
There are a number of things you should be thinking about with regard to beneficiary designations on specific accounts or assets. Here are some of the most important:
- Spousal designations: Spouses have tax advantages over non-spouse individuals when it comes to inheriting some types of assets, such as IRAs, 401(k) accounts, and health savings accounts. Spouses who inherit these assets are able to roll them into their own IRA or HSA accounts, enabling the spouse to defer taxes that might otherwise be imposed sooner. If you want to leave assets to non-spouse beneficiaries, you might consider choosing other accounts, such as bank or taxable brokerage accounts, as these don’t provide special tax benefits to inheriting spouses.
- Charities or other nonprofits: If you are leaving a charitable bequest and have both taxable and tax-deferred (i.e. IRA) assets to choose from, know that tax-deferred accounts make a great charitable gift. When left to individuals, tax-deferred accounts are taxed at ordinary income rates as they are withdrawn, and do not get a “step-up” to fair market value at death. However, a charity or other nonprofit can avoid taxes on the entire bequest of a tax-deferred account. Use a charity vetting site such as charitynavigator.org if you want to make sure your funds will be used well.
- Keep in mind that you can name multiple beneficiaries on a single account. So for example, Fred could have left 50% of his IRA to Ann-Margrock, 25% to Pebbles, and 25% to the charity of his choice. If the beneficiary form has only one or two lines and you run out of room for all your beneficiaries, ask your advisor or call the service provider, to find out how to document the additional names. And be sure to get written confirmation of your choices.
- Name contingent beneficiaries, too, as a backup for the primary beneficiary—just in case something happens to you and the primary beneficiary at the same time.
- Don’t leave assets to minor children or loved ones with special needs, without understanding the consequences. Your advisor can help you with this.
- Don’t name one person as a primary beneficiary with an “understanding” that they will share the money with others you wish to benefit. First, you don’t know that they will remember or otherwise follow through on your wish for them to share the money with others. Second, depending on the amount, they could run afoul of the gift tax rules by trying to share the inheritance with others. Instead, do it right, and name everyone on the form who you want to benefit.
Lastly, and most importantly, do what Fred failed to do: Make beneficiary designation checkups part of a periodic review with your advisor, and compare them to your estate documents when any changes are made, to find and fix discrepancies. As life changes for you, it could be that your beneficiary designations should change, too.