06/17/2013

The Ins and Outs of Beneficiary Designations

In early June 2013, the US Supreme Court directly reinforced the importance of ensuring that beneficiary designations are kept up to date.  In its ruling in the case Hillman v Maretta, the Court ruled that a deceased federal employee’s life insurance policy should go to his ex-wife, and not his widow, because he did not change his beneficiary designation after his divorce, nor did he do so four years later when he married his second wife.  In 2001, the Supreme Court reached the same decision in regard to an ex-wife’s entitlement to an employee’s 401(k) plan in Egelhoff v Egelhoff.

A beneficiary is a person or legal entity that is entitled to receive the proceeds from an estate, trust, retirement account, life insurance policy, or “transfer/pay on death” account. A beneficiary can be one or more individuals or an organization, such as a trust or charity. Primary beneficiaries are the first in line to receive the asset upon the owner’s death, and secondary or contingent beneficiaries receive the assets if no primary beneficiary survives the owner.

Named beneficiaries on insurance policies and retirement accounts generally supersede instructions in wills, making it particularly important to file beneficiary designations and keep them up to date. Periodic review assures that assets will be distributed according to plan.

Beneficiary designations should be reviewed and updated on the occasion of a major life event, such as birth, death, retirement, marriage or divorce.  Updating an estate plan calls for a comprehensive review of beneficiary designations.  Consult with your attorney when you create a will to make sure that there is no inherent conflict between the beneficiaries and assets you identify in your will, and those that are controlled by beneficiary designation forms for insurance and retirement accounts.  If you establish a revocable trust, it is a good idea to designate the trust as the contingent beneficiary so that the retirement plan or insurance proceeds will be distributed according to the terms of the trust.  If you rollover a 401(k) or Thrift Savings Plan to an IRA, take a little extra time to complete a new beneficiary designation form.

Most IRA custodians send a copy of the current beneficiary list to its customers annually.  It is a good idea to keep copies of your beneficiary designation forms. If you do not have copies of your current beneficiary designations, request copies from your account providers or complete a new beneficiary designation form.

Who can be a beneficiary? Most retirement plans, annuities and life insurance policies allow you to decide what happens to your assets after death through the designation of beneficiaries. For most people, their beneficiaries are spouse, children, grandchildren and other relatives. Others include friends, trusts, charities and institutions.  While it is possible to designate a class of recipients (“my living children), it is preferable to be precise by naming specific beneficiaries and the percentage of the asset each is to receive.

Beneficiary designations are generally effective immediately after death.  Because assets controlled by beneficiary designation override a will, they are not “probate” assets.  The advantage is avoiding the expense and time of the probate process, but the downside is an out-of-date beneficiary designation can produce the Hillman v Maretta effect.

Spouses generally take retirement accounts directed by beneficiary designation without tax implication on the death of the first spouse.  Unless the surviving spouse has already turned 70 ½, there are no mandatory annual distributions to generate income tax.  A surviving spouse has the option of rolling over the inherited retirement account assets into his or her own IRA. 

Although a Thrift Savings Plan account works very much like a 401(k), there are special rules to be followed.  A surviving spouse who inherits a TSP actually receives a “beneficiary participant account”, and may be required to start taking required annual distributions as soon as one year later.  The beneficiary participant’s distributions are based on a Single Life  IRS life expectancy table resulting in larger annual payments, and more income tax paid.  If there is still money in the TSP account when the surviving spouse dies, the succeeding heirs must cash in the account.  Many surviving spouses opt to roll over the TSP to an IRA, and avoid the problems of maintaining a beneficiary participant account

Other heirs, though, may face more restrictions and taxable events.  Many types of retirement plans, including 401(k)s and most IRAs, will require your beneficiaries to cash out the accounts and pay income taxes on the full amount, or take required taxable distributions every year in amounts that are based on IRS  life expectancy tables. The beneficiary of a Roth IRA does not owe income tax on distributions, but is required to take minimal annual distributions based on life expectancy.

Minor children, those under the age of 18, cannot directly inherit from an annuity, a retirement plan or a life insurance policy.   Trusts can be established for benefit of a minor and the trust should be named as the beneficiary rather than the child.  Consult with an attorney, if necessary, to set up trusts for them, which can then be named in your beneficiary list.

If you have heirs with special needs, it is almost always unwise to name them individually on the beneficiary designation form.  If they are receiving public benefits that are needs-based, receipt of a steady stream of income could cause disqualification. 

 

 

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