Beneficiary designations are an essential part of our estate plan, but are often overlooked. We establish them when we open an account or start a new job, but then don’t review them for years or even decades. However, circumstances in our lives and tax laws change over time, making beneficiaries more important than ever.
In this post, we will examine why beneficiary selection is important, what types of accounts they impact, how companies distribute assets when one of our beneficiaries dies before us, and key points to consider as you select beneficiaries.
How Assets Are Distributed At Your Death
When we die, there are two ways to transfer assets to others:
Will
This is a document drafted by an Attorney (usually) that outlines who will receive your assets when you die. It distributes all assets that do not have a named beneficiary (house, car, accounts that list estate as beneficiary etc). Upon your passing, those assets go through a legal process called probate, which is a public accounting of your assets to the court. This is a public process that takes some time and costs some money. Once it is complete the assets are distributed to the person(s)/charity(s) you named in your Will.
Named Beneficiaries
When you open certain types of accounts, you can select beneficiaries using a form the company holding the account provides. When you die, the assets in that account will be distributed to whomever is listed as the beneficiary on the form. These assets do not go through the probate process, and it is a fairly quick and private process. Here are some of the types of accounts that support the selection of beneficiaries:
- Life insurance policies
- Retirement accounts (401k, 403b, 457, IRA etc)
- Payable on Death accounts (type of bank account)
- Transfer on Death accounts (taxable investment accounts)
When you update your Will, you need to meet with an Attorney and pay a fee to have your Will updated. When you update your named beneficiaries, you use the form provided by the company holding the account, and there normally is not a cost associated with it.
How Named Beneficiaries Work
There are two classes of beneficiaries that you can choose to designate. You do not need to use both, but it is recommended in most cases:
- Primary Beneficiaries – are the people/charities who will receive the assets after you die (if they are still alive/charity is still in operation).
- Contingent Beneficiaries – are the people/charities who will receive the assets after you and all your primary beneficiaries have died. They usually only come into play if all your primary beneficiaries were to predecease you.
Many times a married couple will name their spouse as their primary beneficiary. Since they live and travel together, it is also advisable to establish contingent beneficiaries, so the funds will go somewhere if they both die together.
If you don’t choose any beneficiaries or put your estate as your beneficiary, then the assets will go back to your estate, and be distributed via your Will. The main advantages of maintaining your beneficiaries are to speed up the distribution of assets and retain privacy.
What Happens If A Beneficiary Dies Before Me?
If a beneficiary dies before the account owner, the owner can change their beneficiaries. However, that is not always possible. In that case, it is important to understand how each company will handle this. Here are two important points to help you:
1. How Assets Get Divided
There are two main ways assets can be divided:
Per Stirpes – is Latin for by the bloodline, meaning everything goes to the children of the beneficiary. For example, if you have two children as your primary beneficiaries and write Per Stirpes after both their names. If one of your children predeceases you, their portion would go to their children (your grandchildren). Their spouse will not receive anything, only your grandchildren. Your surviving child would receive their portion, as they are still alive.
Per Capita – is Latin meaning “per head” or by the person. If one of your beneficiaries were to predecease you, then the assets would be divided over the remaining beneficiaries. For example, if you named your three children as primary beneficiaries and one of them predeceased you, the surviving children would each receive 50% of the assets. The child who predeceased you (and their children/spouse) do not receive anything.
Understanding the difference between per stirpes and per capita is very important, as it can have a tremendous impact on your estate plan if one of your beneficiaries were to die.
2. No Standard Way To Distribute Assets
To further complicate matters, each company handles the distribution of assets differently when a beneficiary dies before the account owner. Since there is no standard across the industry, it becomes very important to ask each provider how they will handle things if a beneficiary were to predecease you.
Here is an example to help you understand why this is so important. Imagine you had two primary beneficiaries and one of them were to die before you. There are three different ways that a company could handle it:
- Return the 50% of the deceased beneficiary to the estate to be distributed via the Will
- Give 100% to the surviving beneficiary or
- Distribute the deceased beneficiary’s portion to his children
It is crucial to understand how each company will handle this. To further complicate this, many account providers use call centers to handle account updates/manage client requests. Unfortunately, some customer service reps are not knowledgeable about the company’s procedures, making this difficult. However, calling at least two times to get different reps will hopefully help you get accurate information.
Additionally, company policy can change, so you will want to verify this information every few years to ensure your wishes will be honored.
Key Points
There are a few points to be mindful of as you consider beneficiaries:
1. Beneficiaries Override the Will
When you die, the beneficiaries you listed on your accounts will receive the assets you chose to leave to them, regardless of what your Will says. For example, if your Will leaves everything to your spouse, but your 401(k) beneficiary is listed as your parents, the 401(k) account will go to your parents.
Your Will does not apply for named beneficiary assets. This is why it is so important to think this through, as many people are not aware how powerful their beneficiary elections are.
2. Mistakes Happen
When you establish or change beneficiaries, normally the company holding your account will send you a letter (or other notification) outlining the changes. It is very important to review this and correct any mistakes immediately. If you don’t correct them, it could be more difficult to distribute the assets after you pass away.
3. Taxes Matter
If you are charitably inclined, your beneficiary choices can have a big tax impact on others. If you leave a Traditional IRA/401(k) to your children, 100% of those funds will be taxable to them as ordinary income. As of 2023, they have 10 years with which to pull out the entire balance of the account and pay tax on it (unless they are older than age 70 1/2, then they could give a portion away using a Qualified Charitable Distribution). If you leave all or a portion of the Traditional IRA/401(k) to a charity, that does not impact the charity at all.
Instead, if you leave your Roth IRA/401(k) to a loved one they will not owe any income tax on the distribution. They still will need to pull the full amount out in 10 years, but it isn’t taxable. The assets that are better left to people are:
- Roth IRA/401(k)/403(b) accounts
- Life insurance proceeds
- Houses/land (if held in your name, they receive a step-up in cost basis to the date of your death)
- Taxable investment accounts (if held in your name, they receive a step-up in cost basis to the date of your death)
Leaving a Traditional IRA/401(k)/403(b) and in some cases annuities to charity can be beneficial for your loved ones and the charity. The charity will not pay any taxes on the assets, and your loved ones will be spared the taxes and complexity of inheriting those assets.
4. Designate Your Beneficiaries, Not Someone Else
Periodically, I will see a client list a family member as the primary beneficiary, who will in turn be expected to distribute the assets upon the client’s death. This is not a good idea, as the family member will be responsible for paying the taxes, dealing with the estate settlement etc, and then have to distribute the assets to the final beneficiary(ies).
In 2023 you can only gift up to $17,000 to any one individual without impacting your own estate and gift tax exemption. If the estate is large enough, it can be very difficult to distribute the assets in a timely manner. The family member will have to keep track of everything and it complicates their own finances. Naming the actual intended beneficiaries on your account documents makes life easier for all involved.
5. Review Periodically
When I meet with clients, this is one of the key areas to review. I have had clients married for years who listed their parents as their beneficiaries, and not their spouse. Things change in your life, and reviewing your beneficiaries every couple of years is a very wise thing to do.
Final Thought
Establishing appropriate beneficiaries and maintaining them over time, is a wise approach. This is not about you, but helping those who you leave behind, and is an important part of our stewardship responsibility. You can either leave a mess, or a well thought out plan.
