While the execution of wills requires formalities like witnesses and a notary, the reality is that a substantial amount of property passes to beneficiaries through other, less formal means.
Many banks and investment companies offer payable on death accounts that permit owners to name the person or persons who will receive the account when the owner dies. Life insurance, of course, permits the owner to name beneficiaries.
These types of ownership and beneficiary designations permit some property to avoid probate, meaning that they will not be governed by the terms of a will. When taking advantage of these simplified procedures, owners need to be sure that the decisions they make are consistent with their overall estate planning. It’s not unusual for a will to direct that an estate be equally divided among the decedent’s children, only to later find that, because of joint accounts or beneficiary designations, the estate is distributed totally unequally, or even to non-family members such as new boyfriends and girlfriends.
It’s also important to review beneficiary designations every few years to make sure that they are still correct. An out-of-date designation may leave property to an ex-spouse or to an individual who died before the owner. This can thoroughly undermine an estate plan and leave a legacy of resentment that most people would prefer to avoid.
These concerns are heightened when dealing with retirement plans, whether IRAs, SEPs, or 401(k) plans, because the choice of beneficiary can have significant tax implications. These types of retirement plans benefit from deferred taxation in that the income deposited into them as well as the earnings on the investments are not taxed until the funds are withdrawn. In addition, owners may withdraw funds based more or less on their life expectancy, so the younger the owner, the smaller the annual required distribution. In most cases, withdrawals do not have to begin until after the owner reaches age 70 1/2. However, this is not always the case for inherited IRAs.
The following are some of the general rules and concerns when designating retirement account beneficiaries:
- Name your spouse, usually. Surviving husbands and wives may roll over retirement plans inherited from their spouses into their own plans. This means that they can defer withdrawals until after they reach age 70 1/2. Non-spouses of retirement plans must begin taking distributions immediately, but they can base them on their own, presumably younger, ages.
- Be careful with charities. While there are some tax benefits to naming charities as beneficiaries of retirement plans, if a charity is a partial beneficiary of an account or of a trust, the other beneficiaries may not be able to stretch the distributions during their life expectancies and will have to withdraw the funds and pay the taxes within five years of the owner’s death. One solution is to dedicate some retirement plans exclusively to charities and others to family members.
- Consider special needs planning. It can be unfortunate if retirement plans pass to individuals with special needs who cannot manage the accounts or who may lose vital public benefits as a result of receiving the funds. This can be resolved by naming a special needs trust as the beneficiary of the funds, although this gets a bit more complicated than most trusts designed to receive retirement funds. Another alternative is not to name the individual with special needs or his trust as beneficiary, but to make up the difference with other assets of the estate or through life insurance.
- Keep copies of your beneficiary designation forms. Don’t count on your retirement plan administrator to maintain records of your beneficiary designations, especially if the plan is connected with a company you worked for in the past, which may or may not still exist upon your death. Keep copies of all of your forms and provide your estate planning attorney with a copy to keep with your estate plan.
In short, while wills are important, in large part because they name a personal representative to take charge of your estate and they name guardians for minor children, they are only a part of the picture. A comprehensive plan needs to include consideration of beneficiary designations as well.