Comprehensive, high quality estate planning involves much more than preparation of wills, trust instruments and durable powers of attorney. Many assets owned by our clients, including life insurance proceeds, employer-provided retirement plans, individual retirement accounts and annuities, are designed to pass at death, initially, not by means of traditional estate-planning documents but, rather, by beneficiary designation. Often, assets that pass by beneficiary designation are among our clients’ most valuable property.
Disposing of property by beneficiary designation has benefits. Assets that pass at the owner’s death directly to named distributees by means of a beneficiary designation form generally aren’t subject to any sort of probate proceeding. In many cases, avoidance of probate is accomplished by completing, signing and submitting a form designed and provided by an insurance company or financial institution at no cost to the asset owner.
Although disposition of certain assets through beneficiary designations can be efficient and cost-effective, the apparent simplicity of naming beneficiaries, particularly when using pre-printed forms offered by an insurance company or a financial institution, frequently masks serious underlying hazards. For example:
• A surviving spouse, if named as beneficiary of the predeceased spouse’s “eligible retirement plan,” has the right to roll over that eligible retirement plan to another eligible retirement plan.1 Similarly, a surviving spouse, if named as beneficiary of the predeceased spouse’s IRA, may treat that IRA as the surviving spouse’s own IRA.2 In either situation, distributions (and income tax on distributions) can be deferred until the surviving spouse reaches age 70½.3 Such deferral is generally impossible if a trust for the benefit of the surviving spouse is named as beneficiary.
• If a trust having multiple beneficiaries (such as an individual’s children or descendants) is named as beneficiary of a decedent’s interest in a qualified retirement plan or IRA, required minimum distributions (RMDs) will be determined using the life expectancy of the oldest such beneficiary4 (thereby causing higher than necessary income tax for all other trust beneficiaries). The “separate account” rules, which ordinarily would enable each distributee’s life expectancy to be used to calculate the RMD amounts payable to such distributee, aren’t available to trust beneficiaries in this circumstance.5
• The insurance company or financial institution may urge its customer to designate beneficiaries by name, address and social security number, but such an approach may be inconsistent with the customer’s true dispositive desires or may not operate as intended if a named beneficiary (such as a child of the customer) predeceases the customer survived by children of his own.
• The insurance company or financial institution may not understand or be willing to follow a direction to distribute among an individual’s then-living descendants per stirpes. The insurance company or a financial institution may consider it impractical to ascertain the identity of such descendants.
• A direction to distribute to a trust will require the insurance company or financial institution to determine who is the duly acting trustee of the trust at the time funds are to be distributed. Some beneficiary designation forms require including the name of the trustee, but that individual may or may not be acting as such when the beneficiary designation is to be implemented.
• If a given beneficiary designation form makes it impossible or awkward to designate a trust, distribution to beneficiaries who are minors or incapacitated is very problematic—often requiring appointment of a guardian or conservator for any such beneficiary.
While there’s no perfect solution to all possible problems arising from completion of beneficiary designation forms provided by an insurance company or a financial institution, the frequency and gravity of such problems can be minimized by adopting the following practices:
• Whenever it’s possible or required to designate beneficiaries in a manner other than merely reciting the names of individuals, use clear, unambiguous and precise language. A beneficiary designation form is a weighty estate-planning mechanism, and its completion should be treated with the same degree of care and attention as is given to preparation of wills and trust instruments. Completion of beneficiary designation forms should never be left to non-estate-planning professionals.
• To the extent possible, ensure that the designation of both primary and contingent beneficiaries is consistent and well coordinated with the asset owner’s relevant estate-planning documents (his will and/or trust instrument). Focus on not only who’s to receive the subject assets but also how and in what circumstance. Also, in any case in which the asset owner’s estate may generate estate tax, consider how to allocate the burden of any estate tax generated by inclusion of the assets in his gross estate.
• Know the rules governing beneficiary designation form completion. If operation of the contingent beneficiary designation may depend on the primary beneficiary’s renouncing or disclaiming, ascertain whether the insurance company or financial institution will treat renunciation or disclaimer the same as having predeceased the asset owner. If the asset in question is an interest in a qualified retirement plan, review the plan document to ascertain the rules. Although the governing documents of qualified plans must comply with all requirements imposed by federal law, they don’t have to include all options allowed by the Internal Revenue Service regarding distributions of a deceased participant’s interest. Instead, plan documents may specify their own rules regarding such distributions, as long as they’re consistent with the Internal Revenue Code and the Employee Retirement Income Security Act. Administrators of qualified plans generally prefer to distribute a deceased participant’s interest in the qualified plan as quickly as possible and with the most administrative ease. Therefore, certain beneficiary designations, as well as certain dispositive schemes, for qualified plan interests may not be permitted by the plan document.
• Whenever possible, obtain confirmation from the insurance company or financial institution that it’s received and accepted the beneficiary designation form as completed. This step may be crucial in any non-standard situation in which the instructions for completing the form may not have been followed with precision or there’s a custom-drafted attachment to the form.
If Form Not Accepted
Unfortunately, an insurance company or financial institution will sometimes refuse to accept a beneficiary designation form completed in a reasonable manner that would carry out the asset owner’s strongly desired objectives. In such a case, if practical, the customer should consider moving his business to a different service provider.
1. Internal Revenue Code Section 402(c)(9).
2. Treasury Regulations Section 1.408-8, Q&A-5(a).
3. IRC Section 401(a)(9)(B)(iv)(I); Treas. Regs. Section 1.401(a)(9)-3, Q&A-3(b).
4. Treas. Regs. Section 1.401(a)(9)-4, Q&A-5(c); Treas. Regs. Section 1.401(a)(9)-5, Q&A-7(a)(1).
5. Treas. Regs. Section 1.401(a)(9)-4, Q&A-5(c).