10 Tips to Ensure Your Beneficiary Designations Square with Your Estate Plan

Penn Mutual

By Penn Mutual | February 3, 2015

Estate planning uses many tools to transfer assets to beneficiaries and heirs. However, there is one area of estate planning that is often overlooked: the disposition of many assets following an individual’s death may be directed not by Will, trust, or other planning document – but by contractual beneficiary designation.

Increasingly, individuals have the option of naming beneficiaries directly on a wide range of financial products. This includes life insurance, annuities, qualified retirement plan interests and individual retirement accounts (IRAs), and accounts with transfer on death (“TOD”) or payable on death (“POD”) designations (commonly used with bank accounts, certificates of deposit, mutual funds and brokerage accounts).

Beneficiary designations are important planning tools – and if the plan is to operate as intended, these assets should be properly coordinated with the broader estate plan and other planning documents. A careless or ill considered beneficiary designation can cause a loved one to be disinherited, heirs to encounter an unanticipated tax bill, or undermine the estate plan.

Here are some practical tips to ensure a coordinated plan which operates to meet intended objectives, including: managing taxation, addressing practical issues and concerns, and ensuring adequate liquidity to support the plan.

1. Ensure beneficiary designations are consistent with current circumstances and objectives:

Changes in an individual’s personal or financial situation, or “life changing events,” are occasions that warrant a review of planning documents, including contractual beneficiary designations. Neglected documents can result in distribution of assets inconsistent with current circumstances and objectives. Appropriate modifications may be needed to avoid a distribution of assets which is unanticipated, or contrary to the intended plan. Significant changes include: marriage, divorce, birth or death of a loved one, change of job or employment status, retirement, changes in income, newly acquired assets, receipt of an inheritance, or changes in personal or business relationships. These occurrences and events should also trigger communication with an attorney and other key advisors.

Example: A divorced client fails to name someone other than former spouse as beneficiary of life insurance policies and retirement plans.

Example: Newly married client revises Will to include spouse; however, children remain sole beneficiaries of the IRA (largest asset), unintentionally disinheriting the new spouse.


2. Ensure beneficiary designations are consistent with the overall estate plan:

When individuals work with their advisors to design and implement an estate plan, they expect all the parts to work together. Contractual beneficiary designations should integrate tightly and consistently with the rest of the plan, taking into consideration the terms and implications of other dispositive documents such as Wills, trusts, “buy-sell” agreements for a closely held business interest, etc. Otherwise, there is no way to provide for smooth and efficient administration, minimize overall taxes, and assure heirs receive neither more nor less than what is intended.

Example: Parent creates Will which includes a testamentary trust for minor children (with final distributions at age 35). However, parent names children as outright beneficiaries of the life insurance policies. Desire to postpone children’s access may be better served if the insurance proceeds are paid to the trust.

Example: Individual intends to divide estate equally among all children (as reflected in Will). However, investment account passes to child who co-manages the account, as sole beneficiary. Upon owner’s death, account becomes property of the beneficiary, with no legal duty to share it with siblings. If account represents significant value, inequities can be unintentionally created.


3. Ensure beneficiary designations conform to other agreements:

Decisions made regarding contractual beneficiaries usually outrank all conflicting stipulations in an individual’s Will. However, if a beneficiary designation and another explicit agreement are inconsistent, a court may overrule the effect of the designation. The terms of another legal document and the beneficiary designation should be properly integrated, so they don’t contradict each other. Beneficiary designations should also conform to the procedures in a plan document administered by an employer such as a pension or profit sharing plan, or the provisions of another legally enforceable contract such as a divorce decree, property settlement agreement, or pre-marital agreement.

Example: Following divorce, insured names children as beneficiaries of group term insurance offered by employer. The divorce settlement declared the former spouse as exclusive beneficiary. A court held the divorce decree trumped the beneficiary designation.


4. Consider the potential implications of naming the estate as beneficiary:

Naming an individual’s estate as beneficiary requires the asset to pass through the probate process. Probate offers the advantage of court supervised collection and distribution of assets. However, naming the estate as beneficiary can also result in significant adverse tax or practical consequences, and depending upon circumstances and objectives, may not be advisable. Property paid to the estate becomes an asset of the estate and subject to claims of the decedent’s creditors (in most jurisdictions). Heirs’ access to funds can also be delayed (up to a year or more). In addition, a beneficiary’s tax deferral opportunities for deferred income assets such as traditional IRAs, qualified plan interests, and annuities may also be limited or compromised.

Example: Insured’s estate is the designated beneficiary of the life insurance policy. The death proceeds may become subject to claims of the decedent’s creditors. Beneficiaries’ access to the proceeds (needed to pay debts, taxes and final expenses) may also be delayed.

Example: Individual beneficiaries of IRAs and qualified plan interests generally have some options regarding the timing of their distributions and tax, including an election to receive distributions pursuant to the beneficiary’s life expectancy (inherited or “stretch” IRA), or the spousal rollover option which permits a spouse to continue deferral of distributions until age 70 ½. However, an interest passing to the owner’s estate must be entirely distributed and taxed within five years of the owner’s death.


5. Consider the use of trusts for protection, flexibility and control:

Trusts can incorporate considerable flexibility and control regarding the timing and circumstances of a beneficiary’s access to funds. Use of trusts, including prudent selection of a trustee, can be particularly advantageous for the following circumstances: asset protection or property management concerns, minor or spendthrift beneficiaries, where an outright beneficiary designation would be otherwise inappropriate or unwise. Consideration should be given to the amount of money at stake, and the beneficiary’s ability to handle a potential windfall. The estate plan may already include one or more trusts which can be considered as primary or contingent beneficiaries.

Example: A client provides significant life insurance legacy to grandchildren but is concerned about their future circumstances in the years or decades to come. The client directs the policy proceeds to be administered through the terms of a trust which incorporates discretionary provisions to postpone distributions until appropriate ages or circumstances. Also, an outright inheritance for a disabled beneficiary may compromise his or her eligibility for government benefits, and may require a special or supplemental needs trust to preserve the legacy.

Example: Although life insurance and pension plans generally receive significant creditor protection, once distributions begin, the “cash in hand” may no longer be protected from the beneficiary’s creditors. An outright beneficiary designation could represent a lost planning opportunity for future asset protection, which could have been provided through appropriate a trust provisions.


6. Make proper use of the beneficiary designation form:

The beneficiary designation form is the principal dispositive instrument for a contractual asset with a named beneficiary. The form provided by the plan administrator, custodian, or issuing carrier should therefore be compatible with the desired disposition of the asset. The form should generally include or accommodate: language which is clear and precise enough to accomplish what is intended; provision for contingent beneficiaries (other than the decedent’s estate); and provisions for distribution of a predeceased beneficiary’s share (e.g., per stirpes or per capita distribution).

Example: Language stating “all my children and grandchildren who survive me” can include current and future grandchildren, and spare the contract owner from having to frequently update the form as the family grows.

Example: Consideration can be given to naming more than one beneficiary, depending upon the amount of money involved, and the individuals’ personal circumstances. The beneficiary designation form should provide for clear identification and description of members of a beneficiary “class”, and clarity regarding what happens to the share of an individual who has predeceased or disclaimed.


7. Include contingent beneficiary designations:

An individual may designate a primary beneficiary, but fail to make contingent choices in the event the primary beneficiary predeceases or disclaims. This is a missed planning opportunity. Administrators and custodians generally assume that in the absence of an “active” beneficiary designation, the owner’s estate is the next one – with potential adverse consequences (as described in item # 4, above). Any disclaimed interest by a primary beneficiary will pass to designated contingent beneficiary or beneficiaries (who would have succeeded to the benefit if the disclaimant had predeceased). Naming secondary or tertiary beneficiaries will also reduce the chance that all of an individual’s prospective beneficiaries will predecease them.

Example: Individual’s spouse is primary beneficiary of IRA. If spouse survives, benefit will be paid directly to the spouse. If spouse predeceases, benefit will be paid to their grandchild (contingent beneficiary), who can elect the “stretch” deferral option.

Example: Insured’s spouse is primary beneficiary of life insurance policy, but may not want to augment her taxable estate. Following insured’s death, spouse disclaims a portion of the proceeds to a trust for the benefit of the children (contingent beneficiary).


8. Consider charitable beneficiaries:

An individual may wish to remember one or more favorite charities in the estate plan, which can include naming a charity as the beneficiary of a life insurance policy, IRA, retirement plan interest, or other account. A charitable beneficiary on a traditional IRA, qualified retirement plan, or annuity will also eliminate federal income tax (and estate tax) on the value passing to charity.

Example: Individual designates charity as beneficiary of a traditional IRA to eliminate income and estate taxes on the IRA upon death. Individual also funds a life insurance policy for the benefit of family to replace the value of the IRA, making a bequest of “taxable” assets to charity and “non-taxable” assets (life insurance proceeds) to family.


9. Remember there are special considerations for pensions and qualified retirement plans:

The Employee Retirement Income Security Act (ERISA) imposes some special rules for pensions regarding beneficiary designations. Absent a written spousal consent filed with the employer, a beneficiary form which names someone other than the participant’s spouse will be ignored. If a plan participant is married, the spouse is the plan beneficiary (unless the spouse consents in writing). Note however, ERISA spousal consent rules do not apply to individual retirement accounts (IRAs).

Example: Married individual designates grandchildren as beneficiaries of 401(k) plan. No spousal consent was filed with the employer. The spouse is the beneficiary of the 401(k) plan, notwithstanding the language of beneficiary designation form.


10: Ensure adequate liquidity to support the plan:

A well-engineered estate plan requires adequate and properly positioned liquidity to support it. Appropriately positioned life insurance can replace income for a surviving spouse or other dependent; help “equalize” inheritances among beneficiaries and heirs; replace the value of a significant charitable gift or bequest; and provide liquidity to cover remaining, debts, expenses, and taxes. A distinguishing characteristic of life insurance is the income tax free death benefit, and with proper planning the death proceeds can also be excluded from the insured’s taxable estate – provided the policy ownership and beneficiary designations are crafted correctly. In order to exclude the death proceeds from the insured’s estate, the policy must be owned by a party other than the insured (e.g., adult child, irrevocable trust). Furthermore, if a third party owns the policy, that same party should generally also be the policy beneficiary – to avoid subjecting the death proceeds to potential gift tax or income tax.

Example: Employer owns policy on an employee’s life and names the employee’s spouse as beneficiary of a portion of the death proceeds. Upon employee’s (insured’s) death, proceeds received by the spouse may be treated as a taxable distribution from the employer (policy owner). The result could be characterized as either compensation or a dividend, depending upon the circumstances.

Example: Wife owns policy on husband’s life. She decides she does not need the death proceeds, and names her grandchildren as the policy beneficiaries. Upon the insured’s death, wife (policy owner) may be treated as making a taxable gift of the death benefit to the policy beneficiaries.


Individuals should engage their personal legal, tax and financial advisors to periodically evaluate their estate plans, including their contractual beneficiary designations.

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