Beneficiary Designations – Part II
Beneficiary Designations – Part II
Alongside wills and trusts, beneficiary designations are becoming increasingly popular as part of a complete estate plan. By simply filling out a beneficiary designation form, individuals can bypass probate and designate who will receive a specific asset upon their death. Today, a variety of assets can be transferred through a simple designation form, including bank accounts, stocks, bonds, retirement accounts, life insurance policies, commercial annuities and, in some states, even land, vehicles and boats.
While the process seems fairly straightforward, problems can arise and mistakes can be made when individuals execute these forms without a complete understanding of how they operate. Therefore, when completing a designation form, the owner should work with an advisor to ensure the form successfully achieves his or her goals and to avoid common mistakes.
This article is the second in a four-part series about beneficiary designations. Last month’s article discussed the different types of beneficiary designations and provided basic information in regard to how they operate. This month’s article, Part II, will explain the most common beneficiary designation mistakes and how to avoid them. Part III will delve deeper into the complexities of using beneficiary designation deeds, also called transfer on death deeds, for real property. Finally, Part IV will present issues related to transfer on death deeds and how to avoid possible missteps.
Beneficiary Designation Missteps and How to Avoid Them
This article reflects general trends among states with regard to beneficiary designations. It is, however, important that professionals look at a specific state’s laws to determine the treatment of a particular asset, account or fund. Additionally, the information below relates to designations for bank accounts, securities, retirement accounts, life insurance policies and commercial annuities. This article does not, however, apply to transfer on death (TOD) deeds for real property. Parts III and IV will discuss TOD deeds in detail.
1. Beneficiary Designation Conflicts with Estate Plan Documents
The owner of a policy, account or fund (hereinafter referred to as “owner” or “client”) must understand that a beneficiary designation supersedes whatever is written in a will or trust. A beneficiary designation form is a contract and, as such, regardless of what a client’s will or trust says, designation forms for retirement accounts, securities, bank accounts, life insurance policies and commercial annuities will control the disposition of the asset at the owner’s death. This is important to understand, as sometimes a client will ask his or her attorney to make changes to a will (or prepare a will) that passes an account or fund to someone other than the designated beneficiary of that account. Regardless of the client’s intent or the timing of the will or trust’s execution, the asset will pass according to the terms of the beneficiary designation.
In Brown v. Brown, 149 So.3d 108 (2014), the Florida District Court of Appeals determined that a payable on death (POD) account passes directly to the surviving designated beneficiary regardless of any contrary intent on the part of the account owner. In that case, Mrs. Brown passed away and was survived by her six children. Her estate included several bank accounts. Some of the accounts were owned jointly by Mrs. Brown and her son Joseph. Other accounts were individually owned by Mrs. Brown at the time of her death but she had a POD designation naming Joseph as beneficiary. The representative of Mrs. Brown’s estate sought a declaratory judgment that all accounts should be included in the estate and divided equally among all six children. The trial court noted that, in Florida, there is a presumption that title to a joint deposit account vests in the surviving owner, but that the presumption can be overcome by proof of contrary intent. The lower court found that there was clear and convincing evidence that Mrs. Brown’s intent was for all her assets, including all bank accounts, to be distributed equally among all her children. As such, the lower court held that all accounts—including the POD accounts—were to be included in Mrs. Brown’s estate and divided equally among all six children.
While the circuit court affirmed the trial court’s determination, the district court reversed the ruling with respect to the POD accounts. The court held that Florida law allows proof of contrary intent to rebut the presumption of ownership for joint accounts. However, no such rebuttable presumption exists for POD accounts. As such, because there was clear and convincing evidence of Mrs. Brown’s intent to leave all assets to her children in equal shares, ownership of the joint accounts was lawfully rebutted and left to her estate. However, her intent could not be used to invalidate the POD designation. Thus, Joseph received sole ownership of all the POD accounts. As a result of the rulings, Joseph was entitled to a share of $44,186.71 from the bank accounts while his siblings’ individual shares from the joint accounts amounted to only $10,155.71.
The Brown case illustrates the need for advisors to educate their clients about how beneficiary designations operate and to ensure that their clients’ designations are in conjunction with their overall estate plans. By coordinating the naming of beneficiaries in a client’s will or trust so that they match the client’s beneficiary designations, unintended consequences, like that which occurred in the Brown case, can be avoided.
2. Owner Fails to Update Beneficiary Designation
Perhaps the most common, and often most detrimental, beneficiary designation mistake is failing to update the designation when the owner experiences a change in circumstances. Beneficiary designations should not be approached with a “one and done” attitude. The last thing the owner wants is for an asset to be distributed to individuals whom the owner clearly would not have selected to inherit those assets. The risk of unintended beneficiary distributions increases the longer the owner waits between periodic beneficiary designation form reviews.
Betsy is the owner of a large stock portfolio. When she registered the stock, she named her fiancé Tom as the transfer on death beneficiary. Right before the wedding, Betsy and Tom had a significant falling out and called off the marriage. Betsy had her attorney prepare a new will. In the will, Betsy specified that her sister, Anne, would receive Betsy’s stock portfolio upon her death. A few years later, Betsy passed away. Even though Anne was subsequently listed as beneficiary of the stock in Betsy’s will, Tom received the stock because the beneficiary designation—not the will—controlled.
It is important that individuals regularly review their beneficiary designations, especially when circumstances change or important life events take place. Events that require a review and/or update of beneficiary designations include: marriage, divorce, birth or adoption of a child or grandchild, death of a family member or friend, a child reaching adulthood (see section six, infra), a serious medical diagnosis, a traumatic event such as incapacitation or perhaps even an estrangement from a close friend or family member.
In 1972, James and Lily were married with one child, Harry. When James landed his dream job in 1975, he designated Lily as the primary beneficiary and Harry as the contingent beneficiary of his very generous employer-provided retirement plan.
A few years later, Lily and James had a second child, Luna. Lily passed away in 2004. Even though both Harry and Luna were included in James’ will, James never updated the beneficiary designation form for his retirement plan. At the time of James’ death earlier this year, Harry was the only living named beneficiary of the retirement account, an asset that represented the bulk of James’ estate. Luna, however, was not named as a beneficiary and so she did not inherit any interest in the retirement account. The effect was that James’ plan, or more appropriately his outdated plan, resulted in an accidental disinheritance of Luna.
Advisors should always make sure to ask about existing beneficiary designations (as well as any joint accounts, jointly held assets and any partial interests in an asset) when working with clients on their estate or financial plans. Once an advisor is aware that a client has a beneficiary designation or any joint or partial interest in an asset, then during subsequent conversations, the advisor should periodically remind the client of the beneficiary designation and make sure that the designation is still in line with the client’s current wishes—especially if the advisor is aware of a significant change in the client’s circumstances or the occurrence of one of the aforementioned life events.
Advisors should also encourage their clients to request an acknowledgement receipt each time they make changes or update their beneficiary designations. This is especially true for account owners who send their designation update forms by mail. Requesting a receipt will not only provide a proper paper record in case there is a dispute in the future, but it also will give the owner peace of mind knowing that upon his or her death the intended beneficiary will be provided for through a properly executed designation.
3. Designated Beneficiary Predeceases Owner or is Not Ascertainable
One aspect of beneficiary designations that attracts many account owners is the ability to avoid passing an asset through probate. However, when owners fail to designate contingent beneficiaries or fail to include enough identifying information, they run the risk of passing an asset through probate due to the failure of a beneficiary designation. By not including a contingent beneficiary, there is a risk that the sole designated beneficiary will predecease the account owner, which would force the asset to be transferred to the owner’s probate estate at death. This can be easily avoided by naming other relatives, friends or charities as contingent beneficiaries and/or default beneficiaries.
Another misstep that could create an ineffective beneficiary designation is failure to provide specific identifying information about the beneficiary. If, upon the owner’s death, the beneficiary cannot be identified, then the asset will be transferred to the owner’s probate estate. Advisors should encourage clients who are filling out beneficiary designations to carefully write down the beneficiaries’ full names (double check the spelling), relationships, social security numbers and addresses to ensure that they can be easily identified upon the owner’s death. Further, the advisor should review these designations to ensure that satisfactory identifying information has been included on the form.
4. Spousal Issues and Joint Accounts
It is important to be aware that some beneficiary designations may require spousal consent. Due to spousal protection laws, many retirement plans (e.g., 401(k)) require the owner to obtain signed consent from his or her spouse before designating someone other than a spouse as the beneficiary of a retirement account (note that a prenuptial agreement typically cannot take the place of a signed consent/waiver form in most states).
For other retirement plans (like IRAs) and POD accounts, the rights of a spouse will usually depend on state law. For example, while federal law does not require spousal consent when naming beneficiaries (see Charles Schwab & Co., Inc. v. Debickero (9th Cir. 2010), 593 F.3d 916, where the court held spousal consent is not required when naming someone other than a spouse as a beneficiary of an IRA), if a married couple resides in a community property state, then consent from a spouse may be required. Recall that in community property states, spouses are entitled to up to half of all marital assets—including retirement accounts. Thus, in order to name someone other than a spouse as a beneficiary of an IRA in a community property state, the non-owner spouse must, in writing, consent to give up his or her community property interest. The following states adhere to community property laws in some form or fashion: Alaska (which is an opt-in community property state), Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. Attorneys with clients who wish to name someone other than a spouse as beneficiary should make sure that the client receives proper written consent from his or her spouse to avoid unintended consequences (e.g., one half of the assets passing to the spouse). Also be aware that in some states, like California, a spouse who has given written consent can later revoke that consent in writing. See Cal. Prob. Code Sec. 5030.
Another issue that sometimes arises involves joint accounts. Where two people hold co-ownership of an account with a right of survivorship, and one of the owners executes a POD form, the POD form will not be effective at death. Instead, all assets in the account will pass to the surviving owner regardless of who was named on the beneficiary designation. This could lead to troublesome results if an owner does not understand the relationship between joint accounts and beneficiary designations.
Robert was settling into retirement and decided to add one of his sons, Abe, as a co-owner of his investment account so that Abe could assist Robert with financial management in later years. The value of the account at the time was over $500,000. A few years later, Robert executed a payable on death document with the financial institution that held his account. He named all three of his sons – Abe, Barry and Connor – as primary beneficiaries to split his account in equal shares. A few years later Robert passed away.
By adding Abe as a joint owner of Robert’s account, multiple unintended consequences resulted. Not only did Robert open his account up to claims from Abe’s creditors and possible gift tax ramifications, he effectively passed all of the remaining account assets to Abe upon Robert’s death. The POD form was trumped by the joint ownership rules and was therefore ineffective. If Robert had instead granted a power of attorney to Abe for his investment account assets, he would have received the financial assistance he desired and his account would have been passed on to all three of his children in accordance with his wishes.
Advisors who are guiding clients through the beneficiary designation process should inquire as to whether the client is sole owner of the asset. If the client is not, and the asset is owned jointly, the advisor should explain that a beneficiary designation form will not be effective unless the client severs the joint ownership (or the other owner consents to give up his or her ownership interest). Alternatively, the advisor could suggest that the client choose a different account or asset (over which the client has sole ownership) to leave to the desired beneficiary.
5. Solely Using Beneficiary Designations to Distribute Assets
While beneficiary designations can be a beneficial and useful component of a comprehensive estate plan, they should not be the only planning tool utilized. An advisor should still work with the client to create the necessary documents in order to plan for future medical and financial decisions and to designate a guardian for minor children. In addition, a trust might be needed if the client plans to designate minor children or individuals with special needs as beneficiaries (see section six, infra, for further discussion).
Advisors should caution their clients against using beneficiary designations for distribution of all assets. If individuals distribute all of their assets through beneficiary designations, the risk is that there will not be sufficient cash available for the executor of the estate to pay off debts, taxes and other expenses of the decedent. Further, when beneficiaries receive assets by way of beneficiary designations, they are under no legal obligation to pay the costs associated with the decedent’s estate. Thus, if an executor is faced with outstanding debts and expenses, he or she may have to initiate legal action to pull assets back into the estate. To avoid this scenario, the advisor could suggest that the client designate his or her estate as beneficiary of one of the client’s POD accounts. Alternatively, the client could include his or her estate as an additional primary beneficiary on the designation form and specify that the estate is to receive a percentage (e.g.,15% or 20%) of the POD asset. This solution provides liquidity for the estate to pay costs and allows the account owner to still pass a majority of the POD asset to family, friends or charity without involving the probate court.
6. Designating Minor Child or an Individual with Special Needs as Beneficiary
Individuals should proceed with caution before designating a minor child as a beneficiary of a retirement plan, IRA, life insurance policy or POD account. If a minor child inherits such an asset by way of a beneficiary designation, the child will receive the asset in its entirety upon reaching the age of majority (18 or 21 depending on state law). Prior to that age, the court will have to select a guardian to manage the property on the child’s behalf. This could entail court costs, attorney’s fees and other expenses. Once the child reaches the age of majority, he or she will suddenly be the recipient of a large amount of wealth. Many 18 to 21-year-olds may lack the financial savvy or maturity to responsibly manage a large acquisition of wealth.
Thus, for large assets, instead of using a beneficiary designation, it may be preferable to set up a trust where the trustee can manage the funds and make distributions in accordance with the terms of the trust and the needs of the child. By going this route, the asset can be distributed over a period of time rather than all at once, thereby avoiding potential financial missteps on the part of the child.
Additionally, a beneficiary designation may not be the best planning tool for beneficiaries with special needs. If an individual is receiving needs-based government benefits, such as Medicaid, Supplemental Security Income or Affordable Housing, then designating that individual as a direct beneficiary of an IRA, life insurance policy or bank/investment account could disqualify the individual from receiving those government benefits. As such, advisors may want to suggest setting up a “special needs trust” for clients who wish to leave assets to individuals with special needs. Creating a special needs trust would allow the client to pass on assets to the individual with special needs, choose a trustee to exercise discretion over the funds and provide for the individual’s wellbeing without jeopardizing his or her eligibility to receive government funds.
Designating the Owner’s Estate as Beneficiary
For certain beneficiary designation forms, like those for retirement plans (including a traditional IRA, 401(k) or 403(b)), designating an estate as beneficiary can effectively subject the decedent’s estate to undesirable taxes. If the estate is selected as beneficiary, then upon the death of the owner the full amount of the plan must be transferred to the estate and, as such, the entire plan’s value will be taxable to the estate. In addition, once an asset is transferred to the estate, it will have to pass through probate court proceedings and will be subject to creditors’ claims.
Advisors can offer two solutions here. First, the owner can designate a family member or friend as the beneficiary. This will avoid the probate process, potential estate costs and creditors’ claims that could arise. If the owner designates a person (rather than an estate) as beneficiary of a retirement plan, then the beneficiary will still have to pay tax on the retirement plan’s value, but the beneficiary could choose to stretch out the distributions (and taxes) over a period of years.
The second solution would avoid negative tax consequences altogether. Instead of choosing the owner’s estate or an individual as beneficiary, the owner could choose to designate his or her favorite charity as beneficiary. For retirement plans and other “income in respect of a decedent” (IRD) assets (including commercial annuities, stock options and U.S. savings bonds) when the asset is transferred to an exempt charity, the charity will receive the asset without payment of income tax. In addition, this transfer would qualify for an estate tax deduction. Thus, often a good solution for the owner is to leave the retirement plan to charity and choose non-IRD assets, like cash or stock, to leave to family and friends. That way, those beneficiaries will receive a step-up in basis and avoid paying tax on the later sale of their inherited assets.
A third option is a hybrid of option one (leaving IRD assets to family) and two (leaving IRD assets to charity). With this option, the owner of the IRD asset would name a charitable remainder trust as the beneficiary of the asset. Then, when the owner passes away, the trust will pay income to selected family members or friends for their lives or a term of years. At the conclusion of the payments, the balance of the trust will be transferred to a charity of the owner’s choice. This option entitles the owner to an estate tax deduction and enables the owner to provide income to family and support a charitable cause.
Rachel has an estate of $1.6 million consisting of a $1 million IRA with the balance being her home, CDs and mutual funds. Rachel wants to provide for her three children when she passes away but also would like to give something to her favorite charity. She decides to set up a testamentary unitrust naming her three children as the beneficiaries. She then revises her IRA beneficiary designation by naming the trustee of the testamentary unitrust as beneficiary.
When Rachel passes away, each child will receive $200,000 outright (from non-IRA assets). The $1 million IRA will be used to fund the unitrust, which will make payments to her three children for their lives. Since the unitrust is tax exempt, no income tax will be due when the IRA is distributed to the trust. Over the lives of the children, the unitrust will pay out approximately $2.5 million of income. Each child will receive about $800,000 of income during their lifetimes. After all three children have passed away, Rachel’s favorite charity will receive approximately $2.4 million.
When used correctly, beneficiary designations can be an effective and useful way to pass on assets to loved ones. By filling out a designation form, bank accounts, securities, retirement funds, commercial annuities and life insurance policies can be transferred without probate to beneficiaries. However, there are many ways that a well-intended designation can cause problems upon the death of the owner. Complications can arise in many instances, including where the designation conflicts with the owner’s estate plan, the owner fails to update the designation form upon a change in life circumstances, the owner does not designate contingent beneficiaries or fails to provide adequate identifying information, the asset is held jointly with a right of survivorship, the asset is community or marital property, the beneficiary is a minor or an individual with special needs or the owner designates his or her estate as beneficiary. These actions can all have unintended and unexpected consequences. As such, it is recommended that individuals work alongside their advisors to ensure that their beneficiary designations successfully effectuate their estate planning goals.