How-to Guides

A major issue in estate planning is who to name as beneficiaries on life insurance policies, pension plan accounts, and IRAs. Often this important decision is given too little consideration. However, naming beneficiaries can be complicated and can present estate and income tax consequences to the beneficiary.

When naming beneficiaries, remember to consider:

• Age of beneficiary - Many policies and plans will not directly transfer assets to minors until a trustee or guardian is approved by a court.
• Ability of beneficiary to manage assets - Perhaps a trust set up in the person's name would be better than a direct transfer.
• Pension plans - Unless waived by the spouse in writing, the law requires a spouse to be the primary beneficiary of the account.
• Naming contingent beneficiaries - Should something happen to your primary beneficiary, the contigent beneficiary would receive your assets.

No matter who is designated, the beneficiaries will receive the death benefit proceeds income tax free. Unlike property disposed of in a will, if the beneficiary designation form is properly completed, insurance proceeds do not go through probate.

For many married individuals, a spouse will be the most logical beneficiary. A trust may be a prudent beneficiary choice, however, if a surviving spouse would not have the ability to prudently manage a large sum of money. The trustees (often a legal entity rather than an individual) would then take charge of managing, investing, and disbursing the policy proceeds for the benefit of the surviving spouse.

Be sure to name contingent or secondary beneficiaries. This means that if the primary beneficiary has died, the insurance proceeds will go to an individual or trust. If there are no surviving beneficiaries, then your beneficiary is generally the "estate of the insured," which means the death benefits end up being probated and ultimately distributed according to the instructions of the decedent's last will and testament. If an individual dies without a valid will (intestate), then the order of legal beneficiaries to whom assets are distributed is specified by that state's law.
Back to top

For married individuals, the law requires that a spouse be the primary beneficiary of an employer-sponsored retirement plan unless he or she waives that right in writing. A waiver may make sense in the case of a second marriage if a current spouse is financially independent or if family members from a first marriage are more likely to need the money.

When retirement plan assets are left intact within an estate, spousal beneficiaries may inherit the money without paying federal estate or income taxes. After age 70 1/2, the surviving spouse must begin required minimum distributions (RMDs) based on his or her life expectancy. The RMDs are taxed as ordinary income. This withdrawal schedule typically is preferred to cashing out the entire bequest at once, which is likely to trigger higher tax payments.

Prior to 2007, nonspousal beneficiaries (children, siblings, unmarried partners, and others) were required to cash out retirement plan bequests between one and five years after the account owner's death. Effective in 2007, employer-sponsored plans are permitted to offer nonspousal beneficiaries the option of completing a trustee-to-trustee transfer from an employer-sponsored plan to an IRA established for this purpose and taking annual distributions based on the beneficiary's life expectancy. Note that many plans have not amended their rules to permit trustee-to-trustee transfers and continue to require nonspousal beneficiaries to follow the five-year rule.

Before taking any action, it is critical that nonspousal beneficiaries determine the rules of the retirement plan in question and also consult a financial advisor with experience in this area. An advisor can make sure an inherited IRA is titled properly, thereby avoiding unnecessary tax payments.
Back to top

With an IRA, spousal beneficiaries may designate themselves as the account owner and treat an inherited IRA as their own. This means a surviving spouse can transfer the assets to an existing IRA or to an employer-sponsored plan. These transfers typically do not trigger tax payments as long as a spouse follows rules for trustee-to-trustee transfers. After age 70 1/2, a spousal beneficiary is mandated to take annual RMDs, which are based on the surviving spouse's life expectancy and are taxed as ordinary income.

Nonspousal beneficiaries cannot transfer assets within an inherited IRA to an existing IRA. Instead, they have two options: They may take all distributions within five years of the original account owner's death or take annual distributions determined by the life expectancy of either the beneficiary or the decedent, whichever is longer.
Back to top

Naming children as beneficiaries may cause unforeseen problems. For example, insurance companies, pension plans, and retirement accounts may not pay death benefits to minors. The benefits would likely be held until they could be made to a court-approved guardian and/or trustee of a children's trust. A guardian, trust, or trustee should be named beneficiary to ensure competent management of the proceeds for the children. By naming a children's trust as a beneficiary, for example, the proceeds could be invested and managed by a competent trustee (a person or institution) you choose. A revocable living trust could also be named as a beneficiary, which keeps the proceeds out of probate.

In November of 2002, the IRS issued regulations that allow nonspousal beneficiaries to annuitize retirement plan distributions over the life of the beneficiary. Check with your employer to find out if this is an option under your plan prior to naming a child as a beneficiary. A competent financial professional and tax advisor can also offer guidance as to whether this action may be appropriate for you.

Special Tax Considerations

• Life Insurance - Benefits are transferred free of income taxes.
• Pension Plans - A nonspouse beneficiary must report the proceeds as "income with respect to a decedent" but can transfer them tax free to an IRA.
• IRAs - Beneficiaries must pay income taxes up to the fully deductible portion of the IRA proceeds and earnings. A spousal beneficiary may be able to treat the IRA as his or her own IRA.

When completing overall estate plans and wills, it is imperative to readjust all beneficiary designations so that your estate plan accurately reflects your intentions. Remember, outdated beneficiary designations (e.g., older parents or ex-spouses) could misdirect the intended flow of an entire estate plan unless changed now.

Also, keep in mind that beneficiaries are paid directly as named. Thus, beneficiary designations are not governed by the directions of last wills and testaments.

As is always the case with estate planning, consult with qualified professionals concerning your particular situation in order to ensure that your beneficiary designations are in tune with your goals.
Back to top