You know estate planning has a lot of moving parts . . . guardianships and trustees for children, real estate and deeds, incapacity planning, charitable giving, business succession, and estate taxes are just a few concerns that clients have when putting together their plan. But one of the biggest problem areas comes from something entirely within the client’s (and their financial advisor’s) control . . . beneficiary designations.
Beneficiary designations operate independently of a will or trust document because these beneficiaries are named under a contractual agreement with the financial company. Life insurance, IRA accounts, brokerage accounts, and any other financial asset that allows the client to choose his or her beneficiary does so under contract law. At the client’s passing, these beneficiaries will receive the client’s funds regardless of what the client has written into a will or trust agreement. If a client has an ex-spouse listed as a beneficiary under a life insurance policy, but leaves everything to the current spouse in a will, then guess who gets the life insurance—the ex-spouse, unless the contract specifies otherwise. And we like it that way!
Beneficiary designations allow a convenient way to augment an estate plan. The assets are kept out of the probate courts and are paid to beneficiaries quickly and privately. Remember, probate is public—a will file can be pulled from the court records any time, along with any documents filed along with it. Probate is also expensive and emotionally draining. Non-probate beneficiary designations make this process easier and less expensive. But this simplicity is a double-edged sword. Because these designations are simple and straight-forward, they are often taken for granted.
Using the wrong beneficiary designations can cause an asset to go to probate when it would not have otherwise. It can cause adverse tax consequences. It can cause someone to receive money when they are in the midst of a divorce or bankruptcy proceeding, causing them to lose their inheritance. Beneficiary designations throw a wrench in estate plans specifically because they are so easy to change. What are the biggest problem areas with beneficiary designations? Let’s look at the top five that I have experienced. The first is, hopefully, common sense:
Mistake #1: Not Keeping Beneficiary Designations Up to Date
Because beneficiary designations are a creature of contracts rather than estate planning law, they operate completely independently of a will or a trust agreement. If a life insurance policy has an ex-spouse listed as the sole beneficiary, then that is where the money is going. The current spouse can certainly sue the ex for the funds, but the chances of winning are slim . . . the benefit of the doubt goes to the person who made the beneficiary designation (and that person, now deceased, is typically not available to testify). If the beneficiary designation is so easy to update, and the client listed his or her ex, then clearly the client meant for these assets to go to his or her ex, right?And we want to keep it that way. If angry would-be beneficiaries were to sue financial companies and win, those companies would probably stop letting us use beneficiary designations altogether. So it remains that if a client’s will says “leave everything to my spouse” and the life insurance beneficiary designations say “leave everything to my parents,” it’s going to the parents. On that note, consider if the beneficiary designation were written so as to give the assets to a beneficiary who is not allowed to own property.
Mistake #2: Naming a Minor as Beneficiary
People who are under age eighteen can’t own property, which means they also can’t inherit property. This might seem like common sense when you think about it, and yet many (if not most) young families name their children as the secondary beneficiary on their financial assets. This beneficiary designations will fail, and an asset that otherwise would have skipped the probate process will now go to probate court. An attorney will work to get these assets into a conservatorship for the beneficiary, which is itself an expensive process. Perhaps even worse, the child will received the assets outright when they are still very young, typically at age eighteen. Have you seen an eighteen year old receive a lump sum of $100,000? I have. It doesn’t go well. Some policies allow a custodian to be appointed when there is a minor beneficiary involved, which allows the custodian to accept the funds on the minor’s behalf. This solves the problem of the minor not being able to inherit property, but it does not solve the problem of the beneficiary receiving a very early inheritance. The solution is often a simple one . . . a testamentary trust can be created directly in the client’s will, and the trust can be named by the client as the beneficiary of his or her financial assets. The trust only exists on paper unless it is needed, at which time it springs into existence and can accept funds on behalf of the beneficiary. The client can determine the terms of the trust . . . does the beneficiary get a lump sum at age twenty-five? Thirty? Never? While in trust, what can the trust pay for? Often college and health expenses are a top priority, with funds to pay for a first home or for a small business sometimes allowed as well. Testamentary trusts solve all kinds of problems, and they’re not just for children. Trusts can be created for spouses, for charities, or for adult children with special needs. But sometimes the client doesn’t know who he or she wants to leave their money to, so they make a big mistake.
Mistake #3: Naming The Client’s Estate
First, let’s revisit the fact that assets with beneficiary designations skip probate, which means they skip the whole “estate” court process. This is often a good thing . . . though there are some merits to probate (particularly when there is a dispute), probate is expensive, time consuming, emotionally draining, and inefficient. Having a valid beneficiary designation makes this process easier because that entire asset skips probate altogether. Nonetheless, clients often want their life insurance policy, IRA, brokerage account, or other asset to just go to their heirs, so they write in that the assets should go to their “estate.” This may seem convenient because the asset will now be controlled by the client’s will . . . which means it is now a probate asset. Not only does this cause the asset to go through probate, it can also has the effect of generating a lot of tax liability. If an IRA or other qualified asset lists anyone other than an individual as a beneficiary, then that entire asset must be paid out within five years. This can be caused in more ways than one . . . by naming an estate, or by naming a trust that is not a “see-through” trust for IRS purposes. If the trust does not qualify for this treatment, it accepts the entire IRA over five years. Tax-wise, this can be disastrous (note that if the trust does not make income distributions, this will be taxed at the much higher trust level). And that brings up the next big point. Beneficiary designations have many consequences, not the least of which can be caused by the next mistake.
Mistake #4: Lack of Tax Planning
To reiterate, leaving tax deferred, qualified assets to a non-individual can be murder on the pocket book, since assets left to non-individuals must typically be paid out within five years. For tax-deferred money, this means the beneficiary’s effective tax rate can hit the stratosphere. Estates and trusts—or at least, trusts that weren’t drafted in anticipation of receiving qualified funds—are taxed at an astronomically higher effective rate than individuals. Fortunately, trusts (including will-based testamentary trusts) can be drafted to be “see-through” trusts, which avoid the five-year distribution problem by allowing the trustee to collect required minimum distributions from inherited IRAs on the beneficiary’s behalf. This treatment is not available for assets left to an estate or if the trust has a non-individual as a beneficiary, such as a charity. But on that note, consider a beneficiary who is charitably inclined. If there is one asset that should likely go to a charity, it is qualified funds. A qualified charity won’t have to pay taxes on funds received from tax-deferred sources like IRAs or 401Ks. A beneficiary will . . . IRA and 401K assets don’t receive the “step-up” given to appreciated non-qualified assets. If there is an opportunity to take advantage of the step-up in cost basis of other assets while leaving assets that would otherwise be taxed as ordinary income to a charitable beneficiary, it could be an incredibly effective tax strategy. Speaking of taxes …
Mistake #5: Forgetting About Credit Shelter Trusts
Minnesota has an estate tax exemption of $1.4 million per person in 2015, rising to $2 million by 2018 (though as of this writing, other proposals are in front of the legislature). The issue with the Minnesota estate tax exemption is that it is not portable . . . if one spouse dies and leaves their assets to the surviving spouse, the surviving spouse does not get to inherit the deceased spouse’s exemption, and therefore can’t “stack” the deceased spouse’s exemption on top of their own. This means the survivor could die with assets above and beyond his or her own estate tax exemption, paying tax on the difference. The solution is to leave assets to a trust for the benefit of the surviving spouse (called a credit shelter trust). If drafted property, this trust will allow the deceased spouse to use his or her exemption, while still providing assets that can be used if the survivor needs them above and beyond the survivor’s own assets. This can save hundreds of thousands in estate taxes. But this only works if the trust is funded. Too often clients pay an attorney to draft an effective credit shelter trust, and then they forget to leave assets to it. If the credit shelter isn’t given any assets, it’s going to be tough for it to shelter anything from estate taxes. Even financially savvy clients can sometimes forget about this aspect of their plan when there are dealing with the myriad of other aspects of their financial planning.
Of course, even proper planning doesn’t guarantee it will work if the client doesn’t keep up with it. Creating an effective testamentary or revocable trust only works if it is funded properly and if the assets with separate beneficiary designations are coordinated with the rest of the plan. A proper financial plan is broad, and estate planning is only one part . . . with the financial advisor as the captain, make sure the task of estate planning is given to a capable co-pilot who can make sure the client sees the big picture.
Philip J. Ruce creates wills and trusts for families who want to feel secure that their loved ones are cared-for. Philip is a trust and estate attorney based in Minneapolis, Minnesota. Philip is the author of Trustee University: The Guidebook to Best Practices for Family Trustees, available at Amazon.com in paperback or Kindle edition (free chapter available here!). He also works with trustees and beneficiaries who need help with their trusts. You can contact him here.