Some of the biggest mistakes I see people – and their advisors – make in implementing an estate plan is naming beneficiaries. Incorrectly naming a beneficiary can spell disaster to your estate plan, including disrupting your dispositive scheme (i.e., who gets what and when), negating asset protection and preservation, and increasing income taxes. It is important to look at your individual situation to determine the best way to name a beneficiary to minimize the impact of these dangers.
Type of Beneficiary Designation Assets
Let’s initially take a look at what type of assets typically name a beneficiary, and we will highlight a few egregious examples of poor beneficiary designations. The two main types of assets that name a beneficiary are retirement type of assets such as a 401(k) or IRA and life insurance. Retirement assets may include both tax-deferred (e.g., traditional 401(k) or IRA) and tax-free (e.g., Roth 401(k), Roth IRA). Individual taxable accounts or cash equivalent accounts may sometimes name a beneficiary if it is a Payable on Death (“POD”) or Transfer on Death (“TOD”) account. It is important to note that there may be reasons why the beneficiaries should not be structured in the same manner across all types of assets.
Disposition Scheme Disrupted
Now that we have seen the typical types of assets that involve beneficiaries, let’s look at the mistakes. First, I have seen beneficiary designations fly in the face of one’s intended disposition of their estate. Let’s say you have 4 children and a $3,000,000 estate consisting of a $1,000,000 life insurance death benefit and the rest of your assets are taxable accounts titled in your individual name. You, as a survivor, leave your individually owned assets totaling $2,000,000 outright to your four children in equal shares as drafted in your will, giving each of your children $500,000 in assets. You had named Jill as beneficiary over your life insurance for a particular reason a number of years ago. While the reason for naming her as beneficiary no longer applies and you had thought all of your assets – including the life insurance – would be split equally amongst your children, the life insurance will pass outright to Jill, giving Jill a total of $1,500,000 of your inheritance and the other three children $500,000 each. Thanksgiving dinner may be awkward.
While life insurance beneficiaries are not the only type of asset where beneficiaries need to be continually reviewed in light of the dynamic aspect of one’s estate plan, similar mistakes occur frequently with naming beneficiaries of IRAs and 401(k)s. This is especially true with these types of assets in light of the ever-changing value of such assets and the constant rolling over such accounts into other retirement accounts.
Increase in Income Taxes
Another mistake with naming beneficiaries is its tax impact. From a tax perspective, it is important to pay particular attention to whom you name as beneficiary over retirement assets because of the tax nature of such assets. With life insurance, the tax intricacies are less complex since life insurance proceeds are generally tax free to the beneficiary. With traditional 401(k) or IRA, the value of the assets (less any tax basis, if any) is generally subject to ordinary income taxes by the recipient individual beneficiary at the time of the distribution of the IRA.
Where a spouse is named as primary beneficiary, the asset can be rolled over into the spouse’s own name and distribution requirements will be based on the spouse’s required beginning date and life expectancy. Thus, this is generally the selected option in most cases. (Second marriage situations are different, and there may be circumstances that suggest a different primary beneficiary when married). The issue usually comes up when non-spouse beneficiaries are named. The beneficiary can generally “stretch-out” the required distributions from retirement plan, potentially allowing them to minimize the income taxes from the IRA withdrawals. With a Roth IRA, the distributions can also be stretched out but the distributions are generally tax-free. The ability to stretch out, or time, the distributions of a tax-free asset of this type can be especially beneficial over the long-term.
Not all beneficiaries receive favorable stretch-out treatment. If the estate is named as beneficiary – or, deemed to be beneficiary for a variety of reasons – then the payout of the IRA has to generally be paid out over a shorter period of time rather than a stretch period (or, potentially rolled over to the spouse’s own IRA). If the decedent died before the “required beginning date” (currently, April 1st of the year after the IRA owner turned age 70 ½ but this may change slightly if the proposed SECURE tax act is passed in 2019), then the IRA has to be paid out within 5 years of decreased IRA owner’s date of death. If death occurs after the required beginning date, then the IRA has to generally be paid out over the balance of the deceased IRA owner’s life expectancy using IRS tables. A shorter payout generally results in lumping of the income into shorter years, often subjecting the IRA payout to higher tax brackets. Higher taxes are usually the result. This can inadvertently occur if the primary beneficiary was improperly named as the estate, if contingent beneficiaries are not thoroughly reviewed, or if a trust is named as the beneficiary of an IRA and the trust is not properly drafted.
I have also seen where beneficiaries of the Roth IRA are either charity (gasp!) or an improper beneficiary. Certainly, it is counterproductive to name a charity since the Roth IRA is already tax free. It is generally more beneficial to consider. With Roth IRAs, the decision on whom to name as beneficiary are a bit more complicated. Of course, if you want to name your children as equal inheritors of your estate, then the common practice is to divide up the Roth IRA equally. In some situations, it may be beneficial to get more creative with naming a Roth IRA. The beneficiaries’ tax rates and the time period of the Roth IRA distributions will impact the decision, and the analysis is not always clear cut due to the many factors involved. In general, a Roth one generally looks to stretch out the distribution as long as possible to garner more tax benefits, all else equal. But, Roth distributions are generally more valuable to those in higher income tax brackets. It may be important to look at the children’s marginal tax rates compared to one another, and perhaps even consider naming the grandchildren as beneficiaries to receive a longer stretch-out. This decision on how to divvy up the Traditional IRA and Roth IRA can be made more complex because of the kiddie tax rules, concerns for asset protection, and other issues.
Changing laws can make the decision more complex. Note that a tax bill (the SECURE Act) was passed by the House of Representatives on May 23, 2019. Among other provisions, this bill – if it ultimately becomes law – would require retirement plan type of assets that names a non-spouse as a beneficiary to be paid out over ten years rather than allowing the payouts to generally be stretched out over the beneficiary’s lifetime. This will change the tax impact and thus the need to revisit how the general scheme of how you leave assets to others. You should stay posted on the passage of that law.
Loss of Asset Protection and Preservation
In addition to accruing higher income taxes, the loss of asset protection may also be the result of improperly naming a beneficiary. Let’s say you are concerned about one of your children,, “Ralphie”, from receiving an inheritance outright for a number of reasons, including the potential that Ralphie would act foolishly with the money, you are concerned about Ralphie getting divorce and allowing your bequeathed assets pass to the ex, or you want to preserve the work ethic that you (think) you have distilled in Ralphie. Your attorney listens to your concerns, drafts a fantastic will, and haves you execute the will that creates a testamentary trust to receive the assets at your death where the assets remain in trust until Ralphie’s later age, say age 60. Now, let’s assume you have a $200,000 taxable portfolio, a $2,000,000 IRA, and a $600,000 home in Brentwood, Tennessee. For simplicity, we will assume a survivor scenario in which the spouse predeceased. If you hold your taxable account and your home individually, such assets pass through your estate according to the terms of your will. Thus, those assets (or the proceeds of such) would be held in trust for your child’s benefit until age 60.
Several years ago, you named Ralphie as beneficiary of your IRA at a time when you were not as concerned about Ralphie’s maturity and when the IRA’s value was much less. Fast forward to today, and all of a sudden Ralphie will receive the $2,000,000 IRA outright, circumventing the will. Ralphie can now cash out the IRA and use the IRA however he desires. If he cashes out the IRA and buys a large home titled jointly with his wife and later divorces, these assets are now likely to be split with the ex upon a divorce. Of your $2.8 million estate that you intended to leave to Ralphie and his children, $2,000,000 will go outright to Ralphie and potentially half of that will go to the ex, depending on what Ralphie does with the assets.
These are just a few of the issues when looking at beneficiary designations. The naming of beneficiaries should take into account your overall estate value, the nature of the assets that comprise the estate, the makeup of your family, your overall estate planning goals, income taxes, and a host of other issues. It is important to work with advisors that take a holistic approach in addressing this and other issues. Serving clients in the Southeast (primarily Nashville, Atlanta, and Florida) and acting as fee-only fiduciaries, the multi-disciplined team at Oasis Wealth Planning Advisors works with clients and their outside advisors in structuring an approach that is effective for clients and their families.