By Jim Terwilliger
We constantly remind clients to review their estate plans, making sure that wills and other estate planning documents (powers of attorney, living wills and health care proxies) are up to date.
Doing so is necessary but not nearly sufficient.
What is equally important is to review and update your beneficiary designations.
First, beneficiary designations override the will and avoid the probate process. That is, assets such as IRAs, Roth IRAs, qualified employer retirement plans, life insurance death benefits and deferred annuities all pass to heirs via beneficiary designations provided to plan administrators by the owner. Generally, the will only becomes involved when no beneficiaries are named. In this case, the estate is the default beneficiary and the will then dictates the ultimate disposition of the funds.
Second, it is far better to name individuals, trusts and charities as beneficiaries of IRAs and qualified employer retirement plans rather than the estate. If the estate is named as beneficiary or becomes the default beneficiary, the estate is generally required to liquidate the entire account and pay the resulting income tax at highly aggressive ordinary income tax rates.
Spouses can do rollovers to their own IRA, enabling them to stretch the IRA over their lifetimes. So-called eligible designated beneficiaries can stretch inherited IRAs over their life expectancies. Other non-spouse beneficiaries can maintain an inherited IRA no longer than 10 years following the death of the original IRA owner, reflecting a change in distribution rules by the 2019 SECURE Act.
Naming a charity as full or partial beneficiary of IRA, qualified employer plan or deferred annuity containing pre-tax dollars is a very smart option to consider. By doing so, not a penny of income tax will ever be paid on these assets.
Rather than leave after-tax dollars to the charity and pre-tax dollars to family members who will then have to pay income tax when distributions are ultimately taken, consider doing just the opposite. Fund charitable bequests from pre-tax accounts via beneficiary designation and fund bequests to family members from after-tax accounts via the will.
The beauty of the latter is that after-tax assets currently get a step up in tax cost basis on death, resulting in no initial income tax consequence to the heirs (at least at the time of this writing).
The above guidance does not hold for Roth IRAs. They are better left to individuals in an estate plan, either directly or through a trust, and not left to charities.
As noted earlier, life insurance proceeds are directed by beneficiary designation. Generally, it is best to direct such proceeds to individuals or trusts. This ensures that the money flows immediately and is not delayed awaiting probate. In some instances, directing all or a portion of these proceeds to the estate is advised to ensure adequate estate liquidity.
Some additional planning issues follow below.
• Name contingent beneficiaries. In most cases, contingent (and sometimes third-level beneficiaries) should be named. This takes care of situations in which the primary and/or contingent beneficiaries pass first. It also allows for a hierarchy of pathways in case the primary or contingent beneficiaries wish to disclaim a portion or all of the bequest. This is a flexible and smart estate planning tactic.
• Keep designations up to date. Typically, beneficiary designations are enacted over a period of years, oftentimes over decades. Over such a span of time, family members die and/or are born, marriages dissolve, and other circumstances change. It is no wonder that designations can end up being highly inconsistent across one’s IRAs, employer retirement plans, and life insurance policies.
Don’t guess on this one. Make a list of all accounts and policies that have beneficiary designations, contact the associated administrators, and confirm. Correct any inconsistencies by filing new forms. Be sure to keep updated copies of all beneficiary designation forms in your personal files.
• Consider the financial and emotional readiness of your beneficiaries. Pre-tax accounts and life insurance proceeds left directly to beneficiaries generally can be fully accessed by such beneficiaries. In other words, they can be emptied and spent. If your heirs are not prepared to handle such an inheritance, consider trusts as beneficiaries. With trusts created during your lifetime or at death through your will, you can specify the ground rules and timeframe for your beneficiaries’ access to the funds.
• Seek professional guidance. As with other important financial matters, be sure to partner with a trusted financial planner and an attorney to ensure that the design of your beneficiary designation array represents your interests and is consistent with your overall estate plan design. This exercise is much too important to leave to chance.
James Terwilliger, CFP®, is senior vice president, senior planning adviser with CNB Wealth Management, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext. 50630 or by email at email@example.com.