When was the last time you checked your beneficiary designations? If you’re like most people, it’s probably been some time.
Estate planning is easy to put off and thinking about what will happen when you die is not fun.
However, because beneficiary designations override wills and trusts, keeping them accurate is one of the most important steps in making sure your wishes are honored.
What is a Beneficiary Designation?
A beneficiary designation is a written instruction that determines who will receive a specific asset or financial account when the owner passes away.
When you name beneficiaries on your accounts, those assets bypass probate and can be transferred directly to the designated individuals (or organizations) upon your death.
Common Account Types
Common account types that allow owners to name a beneficiary (or multiple beneficiaries) include:
- Employer-sponsored retirement accounts (401(k), 403(b), 457(b), SEP and SIMPLE IRAs)
- Individual Retirement Accounts (Roth and Traditional IRAs)
- Non-retirement investment accounts
- Life insurance policies
- Annuities
- Bank accounts
Less common assets where direct beneficiaries can be named include:
- Certificates of Deposits (CDs)
- Savings bonds – Owners of Series EE and I Bonds can name beneficiaries through TreasuryDirect
- Real estate – Some states (including Washington) allow for the use of a Transfer on Death (TOD) deed to name a direct beneficiary for real property
How Beneficiaries Fit Into Estate Planning
Estate planning involves making a number of key decisions and legal arrangements to ensure your assets are distributed according to your wishes, unnecessary taxes and complications are avoided, and your affairs are in order in the event of incapacity.
Bypassing Probate
Probate is the legal process of administering a deceased person’s estate.
This includes paying debts and distributing assets according to their will, and can be time-consuming in certain states.
Assets with beneficiary designations pass directly to heirs without going through the probate process. This can save time, legal fees, and stress.
Do Beneficiary Designations Override Wills?
Short answer: yes.
Because accounts with named beneficiaries bypass the probate process, these assets can be distributed before instructions in a will are considered.
As such, failing to update your beneficiaries can cause confusion even if your will and other estate planning documents are up to date.
Key Terms and Types of Beneficiaries
Primary vs Contingent Beneficiaries
When updating your beneficiary designations, first consider whether each person is a primary or contingent beneficiary.
- A Primary Beneficiary is first in line to receive the asset upon your death.
- A Contingent Beneficiary inherits only if the primary beneficiary has predeceased you and is therefore unable to receive the asset.
Per Stirpes vs Per Capita
When naming beneficiaries, you’ll also need to decide how your assets should be distributed if a beneficiary passes away before you—per capita or per stirpes.
- Per Capita means that only the specifically named person can inherit, which means that in the event they pass before you, their share is to be divided pro rata to the other beneficiaries of the same level (primary vs contingent).
- Per Stirpes means that, in the event your beneficiary predeceases you, their share of the asset is distributed to their direct descendants (children, grandchildren, etc.) rather than being distributed to the other named beneficiaries.
This difference is often overlooked, but important nonetheless. It significantly impacts how your assets are distributed across generations, so choose the option that aligns with your intentions.
POD and TOD
Payable on Death (POD) and Transfer on Death (TOD) are both designations that allow you to name a direct beneficiary of an asset or account.
While similar in nature, POD is typically used for bank accounts and TOD is more common in non-retirement investment accounts.
The minor terminology difference reflects how the assets are distributed. POD accounts are typically paid out in cash, while TOD accounts can be transferred in kind, even if the beneficiary later chooses to liquidate them.
Special Considerations for Retirement Account Beneficiaries
Because of their unique tax treatment, retirement accounts such as IRAs and 401(k)s have specific rules and considerations when it comes to naming beneficiaries, making it especially important to plan carefully to avoid unintended tax consequences.
Naming a Non-Spouse Beneficiary
If you’re married and want to name someone other than your spouse as the beneficiary of an employer-sponsored retirement plan (such as a 401(k)), federal ERISA rules require written, notarized spousal consent.
For IRAs, while spousal consent is not required under federal law, it may be required in community property states like Washington and Idaho, where a spouse could have a legal claim to a portion of the account if contributions were made during the marriage.
These protections are in place to prevent surviving spouses from being unintentionally disinherited of assets they helped accumulate.
Naming a Trust as Beneficiary
While trusts are valuable estate planning tools, it is not typically ideal to name a trust as the beneficiary of a pre-tax retirement account.
Under IRS rules, most non-spouse retirement account beneficiaries must withdraw the entire account within 10 years, potentially creating a large tax burden.
However, when a trust is named as the beneficiary, that window is shortened to 5 years, offering less flexibility to spread out withdrawals and manage taxes.
Additionally, trusts are taxed at much higher rates, further reducing what’s passed to your heirs.
Exception: See-through Trusts
Like many instances involving the IRS, there is an exception to the rule. Certain trusts, known as “see-through” trusts allow the trust’s beneficiaries to be treated as if they were named directly, not subjecting the assets to the 5 year rule mentioned above.
See Quantum’s annual tax guides for current rates and other tax information.
Common Mistakes to Avoid
Overlooking a few key details can have undesirable consequences or create unnecessary complications. Here are a few of the most common mistakes to watch out for.
Not Updating Your Beneficiaries After Life Changes
Life events like marriage, divorce, the birth of a child or grandchild, the death of a loved one, or even the sale of a business can have significant estate planning implications.
Failing to update your beneficiaries after these milestones can lead to unintended consequences. For example, assets could go to the wrong person or someone important could be accidentally left out.
Leaving Beneficiary Designations Blank
Forgetting to name a beneficiary can cause frustrating delays in the administration of your estate. This is especially true in the case of an unmarried person without kids.
Naming Minors as Beneficiaries Without a Trustee or Custodian
Most parents intend for their assets to go to their children after death. However, if your children are minors, state law typically requires a legal adult to manage those assets on their behalf.
Without proactive planning, the court may appoint someone to fill this role, possibly someone you wouldn’t have chosen. To avoid uncertainty, it’s best to designate a trusted guardian and custodian in advance and clearly document your wishes as part of your estate plan.
Naming Your Estate as Beneficiary
Although naming your estate as the beneficiary might seem like a convenient option, it effectively defeats the purpose of naming a beneficiary at all.
Assets directed to your estate must go through the probate process, which can delay distribution. Also, estates are subject to the same shortened 5 year distribution window mentioned for trusts above.
The Role of Advisors
If you have a team of trusted advisors, they can help make sure your beneficiary designations align with your wishes.
If you haven’t looked at your beneficiary designations in a while, take some time to review your beneficiaries and update as necessary. It could save your family a huge headache.
If you’re ready to speak with an experienced team of trusted Spokane Financial Advisors, schedule a complimentary call with our team.
