The bulk of inheritances left to loved ones are usually not held in bank accounts, cars, and other tangible assets. Rather, they are tied up in retirement accounts (such as an IRA, SEP, 401(k) or 403(b)), life insurance policies, annuities, or employee benefit plans or stock options. A will does not govern the disposal of these assets. So, how can you guarantee that your inheritance passes in accordance with your wishes? Review all of your beneficiary designations upon any life changing event, or at least every three years.
Retirement plans and insurance policies are all distributed by beneficiary designations, and are considered “non-probate” assets. Probate is the court-administrated process of taking items that you own in your name individually (i.e. without a beneficiary designation, not titled jointly with someone, and not titled in a trust), and transferring them through your estate and to the beneficiaries named in your will, assuming for these purposes that you have a will (which you should, and if you do not, I would be happy to discuss further). Therefore, your will only “governs” or applies to probate assets, and not the likely greater part of your legacy.
Imagine, for example, you are thirty years old and you have listed your parents as beneficiaries on a $250,000.00 life insurance policy at your new job. At thirty-five, you get married, have a child, and have your attorney draft a will so that your assets benefit your wife and children. You think you are all set, and if you died tomorrow your family would be covered. Unfortunately, if you died without changing your beneficiary designation on that policy, your parents would be receiving $250,000.00 that you meant to benefit your wife and child.
Richard Jones is a single parent and has established a trust in his Will (the “Children’s Trust”) to benefit his children, ages 4 and 7, in the event of his death. If something happened to Richard, he wants to be certain that his children’s inheritances are prudently managed for their benefit by someone whom he appoints, and also that their inheritances are protected from future creditor claims, marital problems, or other similar issues. If Richard’s beneficiary designation on his $500,000.00 retirement account reads “my children,” then Richard’s children will not benefit from the protection of the trust. Rather they will each receive $250,000.00 outright, at age 21. The trust will be bypassed. The correct wording for a beneficiary designation depends entirely on the planning method used, whether a testamentary trust (within your Will) or a revocable trust (separate from your Will). In the example above, the correct beneficiary designation for Richard would have been “Trustees of the Children’s Trust formed under the Last Will and Testament of Richard Jones.”
Beneficiary designations often become stale due to passage of time or the occurrence of life events. Simply forgetting to remove a deceased child (or an ex-spouse) as a beneficiary can have unintended results. If your child predeceases you, is your retirement plan payable to your children “per stirpes” or “per capita?” Per stirpes means that the deceased child’s descendants (children) will receive the deceased child’s share. Per capita, on the other hand, means that your surviving children will divide the proceeds and the deceased child’s descendants will receive nothing. Relying on this language is risky at best. If a beneficiary predeceases you, it is best to immediately change the beneficiary designation to reflect your wishes.
There are also different tax consequences for leaving to your beneficiaries a life insurance policy compared to an IRA. Here is an example.
If Richard Jones left $50,000.00 in a life insurance policy payable to niece A, and $50,000.00 in an IRA, on which niece B is the beneficiary, he may think that he is providing for his nieces equally. But what may appear to be “equal” in his mind will have different inheritance tax and income tax implications for the two nieces. Niece A is the lucky one. She will pay no inheritance tax and no income tax on the receipt of the $50,000.00 of life insurance she receives. Niece B is the unlucky one. She will have to pay both inheritance tax at 10%, plus income tax at her marginal rate, on her receipt of the $50,000.00 IRA. Niece B will receive significantly less than niece A.
I recommend checking your beneficiary designations upon any life changing event or at least every three years, especially if you have plans/policies with several companies or providers. It would also be wise to have an attorney review your beneficiary designations in relation to your current estate plan, as they go hand-in-hand in warranting that your legacy can be used to provide for the ones you love.