Designating Beneficiaries A Critical Step to Allocating Your Assets as You Desire

The beneficiaries and backup beneficiaries named on retirement plans and life-insurance policies must be carefully considered and properly designated. A single person without children, for example, may want siblings, nieces, and nephews to be the beneficiaries, and not parents. Parents could be elderly and institutionalized, which would mean that any funds left to them would be used to cover long-term care.

A minor child of a single person, if named as a beneficiary, will receive the benefits at age 18. A guardian would be appointed by the probate court to hold these funds for the benefit of that child. If there is no beneficiary designation, then the balance of the funds (e.g., by an insurance company) are payable to the estate and, thus, must pass through probate.

It is very important to review the tax issues as they apply to beneficiary designations. Most life insurance is not income-taxable; however, the death benefit is included in the estate for estate-tax purposes. Following are issues that must be considered:

It is possible that, although you don’t currently have a taxable estate, federal or state, your estate may cross that threshold when the death benefit of employer-owned insurance, group insurance, or accidental-death coverage is accepted.

You should not own your own term life insurance policy because this subjects the policy to estate taxes. It is preferable to have the policy owned by and payable to another person (e.g., a family member, friend, or an irrevocable trust).

It is very important to consider the beneficiary of IRAs, annuities, and other qualified retirement plans to be sure that the appropriate person, people, or charities are named. A married individual may receive a spouse’s qualified retirement plan benefits tax-free by rolling the funds over into an IRA.

There is no estate tax or income tax due when you die and leave all assets to your living spouse. However, the income tax and potential estate tax on the estate when your surviving spouse dies is significant.

A non-spouse now has certain options so that he or she does not have to pay taxes in a lump sum on the death of the contributor of the funds. The non-spouse beneficiary may take these funds over five years, take them in a lump-sum distribution, or have them rolled over into a special IRA (decedent IRA), from which they will receive the funds over their lifetime. These distributions have to be made trustee to trustee for the benefit of the beneficiary. A person may not elect to merely take the funds on their own, deposit them in an IRA for themselves, and claim no income-tax status.

A beneficiary may wish to take what is known as a Stretch IRA. In this case, the beneficiary does not necessarily have to pay all of the income taxes in a lump sum, as he or she spreads the distribution over their lifetime. These beneficiaries are not only deferring their taxes, but also protecting these assets in the event that they are sued because the assets are not available as a lump sum.

In addition, when added to the recipient’s own income, a lump-sum receipt of these funds may push the recipient into a higher income-tax bracket, since the receipt of the IRA would be at ordinary income-tax rates. By taking the funds as an annuity over one’s lifetime, the recipient allows the funds to build tax-deferred. Later in life, these funds may be construed as retirement benefits, which may permit the beneficiary to retire early, since they will be a steady stream of income guaranteed for the duration of his or her life.

Even if you are married, it sometimes makes economic sense to consider leaving qualified retirement funds to your children instead of your spouse for income and estate-tax purposes. However, it is a requirement of federal law that your spouse must sign off on the beneficiary form (i.e., you can’t exclude your spouse from being the beneficiary unless he or she signs a written, notarized waiver). It is important to consider income taxes, estate taxes, and the ability of your spouse to survive on only his or her income.

Beneficiary and backup beneficiary designations should be reviewed often to ensure that they are properly completed. Upon your death, the beneficiary designation is payable under a contractual relationship, regardless of what your will says. Therefore, the proceeds are payable to an ex-spouse — for example, in the case of a divorce, which is probably not what you actually want.

Many beneficiary designation forms permit a portion to be paid to multiple beneficiaries rather than having all funds left to one person. Whether a specific beneficiary receives a dollar amount or a percentage of the proceeds, the form should be reviewed often and kept with all other important papers, such your will, healthcare proxy, power of attorney, and trust, if applicable. v

Attorney Hyman G. Darling is chairman of Bacon Wilson, P.C.’s Estate Planning and Elder Law departments, and he is recognized as the area’s preeminent estate planner. His areas of expertise include all areas of estate planning, probate, and elder law. He is a frequent lecturer on various estate-planning and elder-law topics at local and national levels, and he hosts a popular estate-planning blog at bwlaw.blogs.com /estate_planning_bits; (413) 781-0560; baconwilson.com