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Ensure Your Beneficiary Designations are Integrated with Your Estate Plan

January 12, 2021
By: Eva Victor, J.D., LL.M., SVP and Director of Wealth Planning Girard Advisory Services, LLC

Mother holds her son as father smiles upon them from behind.
Estate planning involves the use of many tools to transfer assets to beneficiaries and heirs. However, the disposition of many assets following an individual's death may be directed not by Will, trust, or other planning document, but by contractual beneficiary designation. 

Increasingly, individuals have the option of naming beneficiaries directly on a wide range of financial products. This includes qualified retirement plan interests and individual retirement accounts (IRAs), accounts with transfer on death (“TOD”) or payable on death (“POD”) designations (commonly used with bank accounts, certificates of deposit, mutual funds and brokerage accounts), life insurance and annuities. Beneficiary designations are important estate planning tools, and if the plan is to operate as intended, these assets should be properly coordinated with the broader estate plan and other planning documents. A careless or ill-considered beneficiary designation can cause a loved one to be disinherited, a disabled child to lose government benefits, heirs to encounter an unanticipated tax bill, or undermine the estate plan.

Here are some practical tips to ensure a coordinated plan that operates to meet intended objectives, including: managing taxation, addressing practical issues and concerns, and ensuring adequate liquidity to support the plan.
1. Ensure beneficiary designations are consistent with current circumstances and objectives:

Changes in an individual’s personal or financial situation, or life changing events, are occasions that warrant a review of planning documents, including contractual beneficiary designations. Neglected documents can result in distribution of assets inconsistent with current circumstances and objectives. Appropriate modifications may be needed to avoid a distribution of assets which is unanticipated, or contrary to the intended plan. Significant changes include marriage, divorce, birth or death of a loved one, change of job or employment status, retirement, changes in income, newly acquired assets, receipt of an inheritance, or changes in personal or business relationships. These occurrences and key events should also trigger communication with an attorney and other key advisors.

Example: Divorced client fails to name someone other than former spouse as beneficiary of retirement plans and life insurance policies.

Example: Newly married client revises Will to include spouse, however, children remain sole beneficiaries of IRA (largest asset) - unintentionally disinheriting the new spouse.

2. Ensure beneficiary designations are consistent with other planning documents and the overall estate plan:

When individuals work with their advisors to design and implement an estate plan, they expect all the parts to work together. Contractual beneficiary designations should integrate tightly and consistently with the rest of the plan, taking into consideration the terms and implications of other dispositive documents such as Wills, trusts, “buy-sell” agreements for a closely held business interest, etc. Otherwise, there is no way to provide for smooth and efficient administration, minimize overall taxes, and assure heirs receive neither more nor less than what is intended.

Example: Individual intends to divide estate equally among all children (as reflected in Will). However, investment account passes to child who co-manages the account, and is sole beneficiary. Upon owner’s death, account becomes property of the account beneficiary with no legal duty to share it with siblings. If account represents significant value, inequities can be unintentionally created.

Example: Parent creates a Will which includes a testamentary trust for minor children (providing for final distributions at age 35). However, parent names children outright beneficiaries of life insurance policies. The desire to postpone children’s access may be better served if insurance proceeds are instead paid to the trust, as designated policy beneficiary.  

3. Ensure beneficiary designations conform to other agreements:

Decisions made regarding contractual beneficiaries usually outrank all conflicting stipulations in an individual’s Will. However, if a beneficiary designation and another explicit agreement are inconsistent, a court may overrule the effect of the designation. The terms of another legal document and the beneficiary designation should be properly integrated and coordinated, and not contradict each other. Beneficiary designations should also conform to the procedures in a plan document administered by an employer such as a pension or profit-sharing plan, or the provisions of another legally enforceable contract such as a divorce decree, property settlement agreement, or pre-marital agreement.

Example: Following divorce, insured names children as beneficiaries of group term insurance offered by employer. Divorce settlement declared former spouse as exclusive beneficiary. Court held divorce decree trumped the beneficiary designation.

Example: Life insurance policy beneficiary designation should be consistent with the employer offered split dollar life insurance agreement and policy collateral assignment form.

4. Consider the potential implications of naming the estate as beneficiary:

Naming an individual’s estate as beneficiary requires the asset to pass through the probate process. Probate offers the advantage of court supervised collection and distribution of assets. However, naming the estate as beneficiary can also result in significant adverse tax or practical consequences, and depending upon circumstances and objectives, may not be advisable. Property paid to the estate becomes an asset of the estate and subject to claims of the decedent’s creditors (in most jurisdictions). Heirs’ access to funds can also be delayed (up to a year or more). In addition, a beneficiary’s tax deferral options for deferred income assets such as traditional IRAs, qualified plan interests, and annuities may also be limited or compromised.

Example: Individual beneficiaries of IRAs and qualified plan interests generally have some options regarding the timing of their distributions and income tax, including: a 10 year deferral option; an election to receive distributions over a qualifying beneficiary’s life expectancy (“stretch” deferral option); or the spousal rollover option which permits deferral of distributions until the spouse’s required beginning date. However, an IRA or qualified plan interest passing to owner’s estate must be entirely distributed and taxed within five years of the owner’s death.

Example: Insured’s estate is the designated beneficiary of a life insurance policy. The death proceeds (cash) may become subject to claims of the decedent's creditors. Beneficiaries’ access to the proceeds (needed to pay debts, taxes and final expenses) may also be delayed.

5. Consider the use of trusts for protection, flexibility and control:

Trusts can incorporate considerable flexibility and control regarding the timing and circumstances of a beneficiary’s access to funds. Use of trusts, including prudent selection of a trustee, can be particularly advantageous for the following circumstances: asset protection or property management concerns, minor or spendthrift beneficiaries, or where an outright beneficiary designation would be otherwise inappropriate or unwise. Consideration should be given to the amount of money at stake, and the beneficiary’s ability to handle a potential windfall. The estate plan may already include one or more trusts which can be considered as primary or contingent beneficiary.

Example: Client provides significant legacy (cash, marketable investments) to grandchildren but is concerned about their future circumstances in the years or decades to come. Client directs the accounts to be administered through the terms of a trust (designated account beneficiary), which incorporates discretionary provisions to postpone distributions until appropriate ages or circumstances. An outright inheritance for a disabled beneficiary may also compromise his or her eligibility for government benefits and may require a special or supplemental needs trust to preserve the legacy.

Example: Although pension plans generally receive significant creditor protection, once distributions begin, the “cash in hand” may no longer be protected from the beneficiary’s creditors. An outright beneficiary designation could represent a lost opportunity for future asset protection which could have been provided through the terms of a trust incorporating appropriate provisions.

6. Proper use of the beneficiary designation form:

The beneficiary designation form is the principal dispositive instrument for a contractual asset with a named beneficiary. The form provided by the plan administrator, custodian, or issuing carrier should therefore be compatible with the desired disposition of the asset. The form should generally include and accommodate: language which is clear and precise enough to accomplish what is intended; provision for contingent beneficiaries (other than the decedent’s estate); and provisions for distribution of a predeceased beneficiary’s share (e.g., per stirpes or per capita distribution).

Example: Consideration can be given to naming more than one beneficiary, depending upon the amount of money involved and the individuals’ personal circumstances. The beneficiary designation form should provide for clear identification and description of members of a beneficiary “class”, and clarity regarding what happens to the share of an individual who has predeceased or disclaimed.

Example: Language stating “all my children and grandchildren who survive me” can include current and future grandchildren and spare the contract owner from having to frequently update the form as the family grows.

7. Include contingent beneficiary designations:

An individual may designate a primary beneficiary but fail to make contingent choices in the event the primary beneficiary predeceases or disclaims. This is a missed planning opportunity. Administrators and custodians generally assume that in the absence of an “active” beneficiary designation, the owner’s estate is the next one with the following potential consequences: funds paid to the decedent’s estate may become subject to the creditors of the estate; the property must pass through the probate process, delaying heirs’ access to funds; limits income tax deferral opportunities for IRAs, qualified plan interests, and annuities. Any disclaimed interest by a primary beneficiary will pass to designated contingent beneficiary or beneficiaries (who would have succeeded to the benefit if the disclaimant had predeceased). Naming secondary or tertiary beneficiaries will also reduce the chance that all of an individual’s prospective beneficiaries will predecease them.

Example: Individual’s spouse is primary beneficiary of IRA. If spouse survives, benefit will be paid directly to the spouse. If spouse predeceases, benefit will be paid to their grandchild or to a trust for his or her benefit (designated contingent beneficiary).

Example: Insured’s spouse is primary beneficiary of life insurance policy but may not want to augment her taxable estate. Following insured’s death, spouse disclaims a portion of the death proceeds to the insured’s nieces and nephews (contingent beneficiaries).

8. Charitable beneficiaries:

An individual may wish to remember one or more favorite charities in the estate plan, which can include naming a charity as the beneficiary of a life insurance policy, IRA, retirement plan interest, or other account. A charitable beneficiary on a traditional IRA, qualified retirement plan, or annuity will eliminate federal income tax (and estate tax) on the value passing to charity.

Example: Individual designates charity as beneficiary of a traditional IRA to eliminate income and estate taxes on the IRA upon death. Individual also funds a life insurance policy for the benefit of family to replace the value of the IRA, thereby making a bequest of “taxable” assets to charity, and “non-taxable” assets (life insurance proceeds) to family.

9. Pensions and qualified retirement plans - special considerations

The Employee Retirement Income Security Act (ERISA) imposes some special rules for pensions regarding beneficiary designations. Absent a written spousal consent filed with the employer, a beneficiary form which names someone other than the participant’s spouse will be ignored. If a plan participant is married, the spouse is the plan beneficiary (unless the spouse consents in writing). Note however, ERISA spousal consent rules do not apply to individual retirement accounts (IRAs).

Example: Married individual designates grandchildren as beneficiaries of 401(k) plan. No spousal consent was filed with the employer. The spouse is the beneficiary of the 401(k) plan, notwithstanding the language of beneficiary designation form.

10. Ensuring adequate liquidity to support the plan:

A well-engineered estate plan requires adequate and properly positioned liquidity to support it. In the case of an illiquid estate, appropriately positioned life insurance can provide needed liquidity to cover remaining debts, expenses or taxes. The policy death benefit can also be positioned to replace income for a surviving spouse or other dependent; help “equalize” inheritances among beneficiaries and heirs; or replace the value of a significant charitable gift or bequest. A distinguishing characteristic of life insurance is the income tax-free death benefit, and with proper planning, the death proceeds can also be excluded from the insured's taxable estate - provided the policy ownership and beneficiary designations are crafted correctly. In order to exclude the death proceeds from the insured’s estate, the policy must be owned by a party other than the insured (e.g., adult child, irrevocable trust). Furthermore, if a third party owns the policy, that same party should generally also be the policy beneficiary to avoid subjecting the proceeds to potential income tax or gift tax.

Example: Employer owns policy on employee's life, and names employee's spouse as beneficiary of a portion of the death proceeds. Upon employee’s (insured’s) death, proceeds received by the spouse may be treated as a taxable distribution from the employer (policy owner). The result could be characterized as either compensation or a dividend, depending upon the circumstances.

Example: Wife owns a policy on husband’s life. She decides she does not need the death proceeds, and names their son as the policy beneficiary. Upon husband’s (insured’s) death, wife (policy owner) may be treated as making a taxable gift of the death benefit to son (beneficiary).

Beneficiary designations are an important part of estate planning. It is important to enlist the efforts of your professional advisors to work as a team to produce a plan that accomplishes your ultimate objectives. To have a conversation about your estate plan and, specifically your beneficiary designations, please reach out to a Girard advisor.

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This article is for general information purposes only and is not intended to provide legal, tax, accounting or financial advice. The information in this article, and any opinions expressed therein, do not constitute a recommendation or an offer to buy or sell any security or financial instrument. Viewers should consult with their financial, tax and/or legal professionals before making any financial decisions.