Financial Planning

Understanding how beneficiary designations work with your estate plan

If you have life insurance or a retirement plan you’re certainly familiar with beneficiary designations (BDs). BDs give you the ability to designate who will receive the asset at your death. It’s important to know that a BD trumps your will or trust. So if you gift a life insurance policy to Bob in your Will, but you list Bill on the BD, Bob’s out of luck.

BDs can be an effective tool in avoiding probate or ensuring that assets are distributed to your beneficiaries quickly after your death. However, if not given some thought, BDs can lead to some potentially serious financial and legal problems.

Here’s an example:

Husband and wife with 4 kids ranging in ages from 12-21. 21 year old takes a few college classes but really has no direction in life. He has never been able to save money. Lives at home and plays hours of online poker. 17 year old daughter who does well in school. She's smart with money and saves nearly all she earns. 14 year old son who has special needs. He'll likely never be on his own and will receive government benefits his whole life. 12 year son who is the most difficult child. He's constantly in trouble and was recently caught vaping at school.

Husband has a good job with great retirement benefits. When he initially filled out the paperwork for his 401k he wasn’t exactly sure who to name as beneficiaries. So, like most people in his situation he asked the HR rep helping him with the paperwork, what he should do. The reps advice: “Just name your wife as the primary and each of your kids as contingent. That’s what everybody else does.” Just to be safe, he ran it past his financial adviser who said that's how advises people to do it. Husband and his wife did the same thing on their life insurance policies.

Sounds like good advice, right? You want your assets to go to your spouse and kids.

Husband and wife are involved in a horrible car accident and both die. Fortunately, they had planned for this sort of situation. They both had a $500k life insurance policy and husband had $200k in his 401k. They had Wills and had named guardians for the 3 minor kids On first glance it looks pretty good. But is it?

What happens with the insurance policies and the 401k?

The 21 year old gets a check from the insurance company for his 1/4 share ($250k) and an inherited IRA for $50k. Zero provisions on how to spend it. Do you think he's going to keep taking college classes? Unless someone helps him, this money's gone in 18-24 months.

17, 14 and 12 year olds. Because they’re all minors, they can’t own these assets themselves. Instead, a custodian is appointed who handles the assets on their behalf. When they reach a certain age (21 in Colorado) the kids gain control of the money. The 17 year old seems like she might make good decisions, but who knows. What about the 14 year old with special needs? Inheriting that kind of money will disqualify him from Medicaid benefits because it puts him well over the allowable asset limit. Oops. (Much more on special needs planning next time). Troubled 12 year old? Serious drug user by age 21. $300k is going to ruin his life.

Husband and wife never intended for this to happen. They always wanted the best for their kids and assumed that leaving money for their kids in case something like this happened would only help them. So how do you prevent this from happening?

First: If you have a financial adviser, share this example with them and see what they say. It might be time to get a new financial adviser.

Second: Talk to an estate planning attorney (not your neighbor who's a personal injury attorney or your sister-in-law who practices patent law) who can work with you to prevent something like this from happening.

Third: If necessary, update your beneficiary designations.

Why Putting Off Your Estate Planning Is A Bad Idea

A friend of mine is a pilot. He was recently flying with his wife when he experienced problems with his plane. His plane lost power at 12,000 feet and he was forced to make an emergency landing in a snowy field. His plane came to a stop less than 100 yards from a 700 foot cliff. Fortunately, he and his wife were unharmed. They also have their estate planning in order. 

This experience reminded me that we never know when tragedy might strike. And it's not just limited to what we might consider a high risk activity like flying a plan. A car accident or a botched surgery could be life-changing. There's really no reason to put off your estate planning. In fact, getting it done will create a sense of peace.

Call me today for your free estate planning consultation. 

What To Do With An Inherited IRA

 

IRAs are unique creatures. There are very specific rules that apply when these are inherited. There are several distribution options that apply to both spouses and non-spouses. Each option has its own tax implications. Regardless of your relationship, you can:

  • Inherit the IRA. You can transfer the proceeds into an inherited IRA for your benefit so that the assets can grow tax-deferred. You can then take distributions over your lifetime and enjoy the benefit of tax-deferred growth on the assets remaining in the inherited IRA.
  • Take a lump-sum distribution of the assets. Once you've inherited the IRA, you can take a lump-sum cash distribution. However, you'll lose the benefit of tax-deferred investing and, because the money counts as ordinary income for the year in which you receive it, you may end up with a sizable tax bill.
  • Refuse to take ownership of the assets. You have the right not to take the inheritance. This refusal is called "disclaiming" the inheritance. If you do, the surviving primary beneficiaries, or secondary beneficiaries if there are no other primaries, are entitled to the undistributed amounts. 

If you inherit an IRA, whether it's a traditional or Roth, the IRS requires you to take at least some of the account balance out each year. It's called a required minimum distribution (RMD). (Depending on your situation, you may be able to wait until you reach age 70½ to take your first RMD.)

The amount of your first RMD and when you need to take it to avoid tax penalties are based on a few factors:

  • Your status as a surviving spouse, a spouse who's also one of several beneficiaries, or a nonspouse beneficiary.
  • The date of the original owner's passing and whether the owner was older or younger than age 70½ at the time of death. In most cases, you'll need to take your RMD by December 31 of the following year. However, if the owner passed after reaching age 70½, you may also be responsible for taking the owner's remaining final RMD by December 31 of the year of death.
  • If other beneficiaries were named. The life expectancy used in the RMD calculation depends on whether each beneficiary has established his or her own inherited IRA by December 31 of the year following the original owner's death. If so, you can use your own life expectancy. However, if the account isn't split into separate IRAs by the deadline, the oldest beneficiary's age is the one used to determine the RMD amounts for all the beneficiaries.

Before you decide on a distribution option, you should talk to an attorney who has experience with these decisions. The potential tax implications and loss of tax-deferred growth are serious issues with substantial financial consequences.