Beneficiary designations for retirement plans, life insurance and IRA’s

Many assets do not pass through the Will as part of the probate estate, but instead pass outside of the Will by beneficiary designation. Assets such as life insurance, annuities and qualified retirement plans [IRA’s, 401 (k)’s or 403(b)’s] use beneficiary designations to determine the asset’s recipient. Most beneficiary designation forms give the account owner the ability to name a primary beneficiary and contingent beneficiaries, in the event the primary beneficiary either predeceases the account owner or decides to disclaim (give up) his or her interest in the account.

Preparing and filing proper beneficiary designations is essential to implementing a well-coordinated and effective estate plan. Often a couple may execute Wills that establish trusts for the benefit of their minor children or grandchildren. If life insurance or retirement plan assets name the minor children or grandchildren directly as the beneficiaries, rather than the trusts established by the couple’s Wills, the trusts may not be funded and the proceeds of the life insurance and retirement plans will be administered by the court system and distributed when the infant attains age 18. This may be contrary to the trust provisions established by the Wills.

Another example illustrating the importance of proper beneficiary designations involves a credit shelter or disclaimer trust. An estate owner sets up a credit shelter or disclaimer trust in his or her Will to shelter assets from estate taxes. If life insurance proceeds name the decedent’s spouse as the beneficiary, rather than the trust, the trust may be under funded. This may result in the payment of necessary estate taxes at the spouse’s subsequent death. The estate plan, so carefully crafted during the estate owner’s life to minimize estate taxes by using trusts in his or her Will, is defeated.

When properly implemented, beneficiary designations can provide flexibility in the estate planning and administration process. This allows the executor and beneficiaries the ability to make decisions after the estate owner’s death, based on information available to them at that time. For example, a life insurance policy may name the decedent’s spouse as the primary beneficiary and a credit shelter trust as the contingent beneficiary. This designation allows the decedent’s spouse to evaluate his or her income and asset needs at the time of the spouse’s death. The spouse may decide he or she needs the liquidity from the life insurance proceeds, so collects the proceeds directly. Alternatively, the spouse may possess sufficient assets apart from the life insurance and instead decide to disclaim the life insurance proceeds with a view towards minimizing estate taxes at his or her death by funding the credit shelter trust named as the contingent beneficiary. Effective estate planning provides options to estate beneficiaries based upon economic, tax and lifestyle considerations existing when the estate owner passes away.

Retirement Plans

Naming proper beneficiaries for retirement plan accounts is particularly important as most accounts are subject to both estate tax and income tax. Over the past 20 to 30 years, retirement benefits have undergone dramatic transformations. Nearly extinct are defined benefit plans such as pensions, where the employer pays the former employee a regular benefit so long as the former employee lives. Replacing defined benefit plans are defined contribution plans, such as 401 (k)’s or 403 (b),s, where the employer contributes a fixed amount or percentage of the employee’s salary to an investment account. These defined contribution plans may also receive elective deferrals of salary by the employee. The employee, not the employer, often directs the investment of the proceeds and bears the risk of any gains or losses in the account. The employee normally pays income tax when benefits are withdrawn by the employee, not when the contributions or deferrals occur. Deferring income tax allows the account owner to “borrow” the deferred income tax and capture any growth in the amounts deferred over time.

With retirement plans making up a greater percentage of an individual’s total estate, designating proper beneficiaries is of paramount importance. In many circumstances it is desirable to preserve income tax deferral on retirement assets for as long as possible. A surviving spouse may have the ability to roll plan benefits into his or her own IRA and continue to defer income tax. In other situations, a beneficiary must take minimum distributions based on the account owner’s life expectancy. Naming a “designated beneficiary” may allow an individual or trust to establish an “inherited IRA” for the inherited benefits and take minimum distributions over the beneficiary’s life expectancy. Failing to name a proper beneficiary may cause a beneficiary to face immediate income taxation on the retirement plan proceeds, and significantly reduce the long-term growth potential of such asset. Timothy Muck, Esq. may be reached for questions at (585) 324-5727.