If something were to happen to you tomorrow, where would everything you own go? Can you say with certainly who your 401k would go to? What about your IRAs and life insurance benefits? Bank accounts?
That is the purpose of a beneficiary designation. Many people set up beneficiary designations when they open an account, which may have been years, or even decades, ago. The problem is that life happens. Marriages, divorces, births, and deaths are experienced by many people over their life. Hopefully you went the extra step of setting up a will and maybe even a trust. Regardless you need to be proactive since beneficiary designations usually supersede any other instructions, including your will! Are you making sure your current wishes are reflected in the beneficiaries you have chosen? A good start is understanding how the process works.
What are the different types of beneficiaries?
There are a few major ways to categorize beneficiaries. They include the order in which assets are received as well as who is the recipient.
The order:
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Primary Beneficiary – The first person who would receive the assets you are leaving behind would be called the primary beneficiary. You can designate one person to be the only primary beneficiary or split it between multiple people (1 @ 100%, 2 @ 50% each, 4 @ 25% each, etc.…). Normally if one of the primary beneficiaries dies then the assets are split evenly among the remaining primary beneficiaries.
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Secondary Beneficiary – A secondary, or contingent, beneficiary is the next in line if all the primary beneficiaries predecease or die simultaneously with the account owner. A common example is spouses who each listed each other as the only primary beneficiary but both die in a common accident. Contingent beneficiaries are often left blank because it is perceived that they won’t be needed but they are an important part of planning.
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Per Stirpes or Per Capita – This helps provide general rules within beneficiary designations governing how to divide up assets. Think of it as “in addition to” the primary and secondary order. Per stirpes (by branch) means that if one of your beneficiaries dies then their share is divided evenly between their children. If Jim and Pam are both 50% beneficiaries and Jim passes away prior to the account owner, his two kids would equally split his 50% share. Per Capita (by head or per unit) means that the entire amount left is divided equally among all eligible beneficiaries. This is the most common approach as noted in the primary beneficiary description. Using the previous example, it means if Jim passes prior to the account owner, Pam would now receive 100% and be the sole beneficiary.
The type:
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Person – An individual such as a family member or friend.
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Trust – You can name a trust as your beneficiary. An ILIT (Irrevocable Life Insurance Trust) is one of the most common, but there are several types of trusts that can provide extra protection or control over the proceeds.
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Charity – Assets can be left directly to a charity on a beneficiary form. Pre-tax qualified accounts can make good matches for this strategy since the charity doesn’t have to pay any of the taxes like a family member might.
There are more examples we left out because they are rarely used. For example, beneficiary designations can be revocable, meaning they can be changed, or irrevocable, meaning the designation is final. Almost all beneficiary designations are made revocable except in limited circumstances like if you were afraid you might be convinced / coerced into changing them at a time of limited capacity.
What types of accounts have beneficiaries?
There are four main types of accounts that have the option of listing beneficiaries. They are qualified accounts (meaning 401(k), 403(b), IRA, Roth IRA, SEP, SIMPLE, etc.), life insurance policies, annuity contracts, and 529 College Savings plans.
Although they all have beneficiary designations, they should not be treated the same. The reason is each account has different rules and tax implications that can, and should, be considered when naming beneficiaries. One prime example is the advantages spouses have enabling them to make an IRA their own instead of transferring it to an inherited IRA account. That allows them to continue to defer any required distributions until their own required date instead of having to start them immediately like a non-spouse beneficiary would.
Don’t forget to check with your employer for any and all benefits that could have a beneficiary designation such as pensions, group life insurance, or HSA accounts. These are easy to miss and may need to be redone if your company changes who is administering the benefit.
Do I need to name beneficiaries if I have a will?
Yes. Just to be clear, a will is used to create an orderly disbursement of your probate estate. The KEY benefit of using beneficiary designations is that it allows the proceeds to pass to the beneficiary WITHOUT going through the probate process. No fees, no courts, fewer delays. This allows for the most efficient transfer of assets after your death, but also leaves a much small, simpler, and less costly probate experience for your loved ones.
That doesn’t mean a will is not a vital part of your estate plan. You can’t name a guardian for your minor children via a beneficiary designation. Nor can you leave your complete set of 1989 Topps baseball cards, if you by chance saved it. The point is beneficiary designations should work together with your will and any trusts to ensure there is a plan for all the things you care about.
Can I name my kids as beneficiaries?
Yes, but you shouldn’t. A minor can’t take control of qualified accounts or receive life insurance proceeds directly. Absent any other instruction the probate courts would have to appoint a guardian for the money until your child reaches the age of majority, usually 18 or older (see Alabama, Mississippi, & Nebraska). If you set up a will and appointed a guardian to care for your children that doesn’t solve the problem. They are two distinct things and you may not want the same person who is raising your kids managing a large sum of money. Being a great parent and being financially knowledgeable don’t always go together.
So, what is the solution? In an ideal world it would be to establish a trust to receive the assets and manage them for the absolute best interest of your children. This can be done through a testamentary trust that is created upon your death. Warning – If you plan to leave an IRA for a minor inside a trust make sure it can qualify for the Stretch IRA provisions (allowing the required withdraws to be spread out across their lifetime). Not all do so a qualified estate planning attorney should be consulted.
Thankfully, if you don’t want to establish a trust do to cost, or you just wanted to leave something for a young niece or nephew, there is another option. When you are filling out the beneficiary form you can list a trusted person as custodian for the benefit of the minor allowing them to set up an UTMA (Uniform Transfers to Minors Act) or UGMA (Uniform Gifts to Minors Act) account which they oversee. It also allows the custodian to set up an inherited IRA for IRA assets passed on including managing the required distributions required by law. Be careful to discuss this with each institution to confirm the wording and forms required to execute this properly.
How do I pass on accounts that don’t have a beneficiary designation?
What about checking, saving, and brokerage accounts? That depends on the relationship with the beneficiary. If it is a spouse, the easiest path may be to change the accounts to jointly owned. Legally this is called Joint Tenants with Rights of Survivorship (JTWROS) and gives each spouse equal ownership in the entire account. When one spouse passes, the other automatically becomes the sole owner. The added benefit is that this keeps the assets out of probate, making it a fast way to transfer funds to the other spouse when they are likely needed most.
If it is someone other than a spouse the simplest way is to set up a TOD, or transfer on death, plan for the accounts. This allows the individual you name to take over those accounts with relative ease, usually only needing a copy of the death certificate and proof of identification.
What if you want to have some control or protection over the accounts you leave?
Many people want to leave assets to others, commonly adult children, but want to add additional layers of protection or control. There could be fears of future creditors, an ex-spouse, or just the possibility that the money will be wasted. These are scenarios where, once again, legal counsel is so important. The most common method of solving these issues is through the use of a trust, where an attorney can take your specific concerns into consideration and design a solution to address them.
How should I choose my beneficiaries?
There can be a lot to think about when choosing your beneficiaries. We’ve touched on multiple points already but sometimes having an order to follow can simplify the process.
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First determine who you would like to include. Are you only including family, or will friends and charities be part of the equation?
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Next, decide how you want everything to be split. Working with percentages is better than dollars when leaving assets that fluctuate a lot in value (stocks), however the opposite is true if you are dealing with something that loses value over time due to inflation (cash).
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Then review the types of accounts you have to see how you can maximize what you leave behind. A beneficiary in a high tax bracket might be better off with stock that will receive a step-up in basis at your death, enabling them to sell it with no, or little, taxable gain. A young beneficiary may be a better fit for leaving a qualified account if they are in a very low tax bracket and can spread out the required distributions over a long time horizon.
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Finally, plan for special situations that may require an attorney or appointment of a financial custodian to execute.
One pitfall to avoid is leaving everything to one family member, usually the “responsible” one, and have them distribute it based on your verbal instructions. When it comes to money and family leave nothing to chance. You run the risk of that person using their own judgement to disperse your assets or ruining their relationships with other family members who think they were treated unfairly. You want everyone to know that the decisions were made as you wished.
Understanding Beneficiary Designations
Beneficiary designations are an important part of both financial and estate planning, despite being often overlooked. Just like the need for life insurance, it requires us to think about a time when we are no longer here, which can be hard. Fair or not, it also makes us assign percentages to people or organizations we care deeply about. How do you split up assets between two children when one could really use the money and the other is doing great? Should you leave something for grandchildren or trust their parents to include them? Do you tell anyone that they are a beneficiary ahead of time? These questions are both deeply personal and unique to each family.
The phrase “the best is the enemy of the good” applies to all walks of life and this is no exception. Follow the steps and don’t leave any beneficiary designations blank. You can always go back and change them, in fact many companies let you do so online. Don’t risk being a part of an estate horror story trying to make a perfect plan. After reading all this, our single best piece of advice is to just get started.