Pitfalls and Dangers in Estate Planning: Beneficiary Designations on Financial Accounts, Life Insurance and Retirement Plans
Written by: Wills, Trusts, & Estate Administration
Beneficiary designation forms seem easy, right? Fill out the form, send it in. These days it’s often easier still—a few keystrokes online and you’re done. In many cases, you accomplish exactly what you think you want. Unfortunately, these forms and how they are completed can have also have unintended, unanticipated, and unfortunate consequences. These risks are often exacerbated by the ease of making online changes, without having ever consulted with your estate planning attorney or financial adviser.
Let’s start with a brief review. When a person dies, either with or without a Will, his or her estate must be administered. If property passes through the estate, it is generally termed “probate property”, and is disposed of in accordance with the terms of the Will if one exists, or otherwise by provisions of state law. If such property instead passes by operation of law or pursuant to a beneficiary designation, it passes outside of the estate, and it is termed “non-probate property”, and is not controlled by the Will or state law provisions. (For example, if I own a $100,000 life insurance policy and name John Doe as the beneficiary, but my Will states I leave my $100,000 insurance proceeds to Jane Doe, then John will take it. The Will cannot override the beneficiary designation).
Non-probate property includes real estate held as joint tenants with rights of survivorship, most joint checking and financial accounts, along with both life insurance and retirement plan benefits where a valid beneficiary designation has been filed naming a beneficiary.
So let’s look at a few common problem areas:
1. Listing a co-owner/beneficiary on a financial account. We’ll start with this one, because it is the most common. Frequently I have clients who come in and are pleased to tell me that they named their son, daughter, or whomever as a co-owner of their account, or as the POD (pay on death) beneficiary. In the client’s mind, they did this either because they thought it would make the probate process easier, or because they wanted someone to have access to pay their bills if they become incapacitated. Granted, that result can be accomplished by the change. But there are several potentially negative consequences. First, by doing this, the client has now converted the account to non-probate property. (For example, let’s say you have a $100,000 CD. You name one child as a co-owner or POD beneficiary — in your mind, so they can access it for your benefit if you become incompetent or pay for your funeral. You have 2 children, and your Will provides each share in your estate equally. Unfortunately, since this CD will pass by operation of law to the survivor or POD beneficiary on the account at your death, your other child will not share in it, unless the named child willingly gifts half of it to the sibling). Second, you have potentially made this an asset that a creditor of your child can pursue, even while you are alive, if your child is a co-owner. Third, if it’s a stock investment account, your action likely results in the child taking a lower basis at your death, meaning you have created the potential for capital gain tax where it would not have otherwise existed.
2. No beneficiary designation on file. If a life insurance policy has no listed designated beneficiary, then it will pass as part of the probate estate. This is often not a problem—except where the estate is otherwise insolvent and/or has significant creditors. For life insurance (or at least term insurance), if the proceeds are payable pursuant to a beneficiary designation on file, it is not subject to claims of the creditors of the estate or of the decedent. If, on the other hand, there is no beneficiary designation on file, and it is paid to the estate, it is reachable by creditors.
The problem is compounded for qualified retirement plan benefits, as there are also tax consequences. If there is no designated beneficiary, or the beneficiary is the estate (unless very specific language is included in the Will), then all of the retirement accounts must be paid out within 5 years of the date of death, accelerating taxation. If, on the other hand, there is a valid beneficiary designation in place, the retirement assets can either be rolled over (if the spouse is the sole beneficiary), or continue to be paid out over a longer period, minimizing taxes and allowing for the accrued benefit to continue to grow tax deferred.
3. Old or incorrect beneficiary designations. We see this most frequently in second marriage situations, but it also occurs in other scenarios. If you have an otherwise valid beneficiary designation on file with the insurance company or retirement plan sponsor naming your former spouse, guess what? Yes, you guessed it. Your former spouse still receives the benefit and is completely within his or her legal right to take it. While a divorce legally separates the parties, and while state law treats a former spouse as having predeceased so that the ex-spouse does not benefit under your older Will, the divorce does absolutely nothing to cure this problem of beneficiary designation. The only way to cure this is with a new beneficiary designation. This problem arises more frequently than you might expect.
4. Beneficiary Designation is inconsistent with the Will and overall estate plan. This comes up most frequently with Wills that create trusts, but it can also occur in other situations. Let’s say your Will creates a marital trust for your spouse. Let’s further assume that a significant portion of the funding is intended to be though either your interest in your retirement plan or IRA, or a large insurance policy you own. Yet you failed to heed your attorney’s advice, and the beneficiary designation still provides the spouse is the outright beneficiary. In that event, the asset is a non-probate asset, never passes through the estate, and thus cannot be used to fund the trust your Will intended to create.
Along those lines, a similar problem frequently occurs where minor children are named on the beneficiary designation form. Where you have minor children, your Will probably has (or certainly should have) contingent trust provisions that would create a trust for the minor children at your death. However, if your minor children are listed as the direct beneficiary, then the asset will not be a probate asset, and thus not available to fund the trust. Instead, it will pass to the children, though since they are minors, it will go into a conservatorship, and they will be entitled to the full amount at age 21, which is generally contrary to most estate planning clients’ wishes.
5. Beneficiary designations naming the estate. One might get the impression based on the above points that one should never name the estate as the beneficiary of a life insurance policy or retirement asset. This is not at all always the case; in fact, many times this will be exactly what needs to be done. However, it should be intentional and thought out, upon advise of your estate planning attorney or financial adviser, and never as a “default. Otherwise, you run the risk of unintended, unanticipated, and unfortunate consequences.
IN SUMMARY, proper execution, and occasional review, of beneficiary designations is an integral part of your estate plan. These designations can have a significant benefit, or can virtually destroy the well laid plans for your estate.