The Dangers of Improper Beneficiary Designations
Your heirs could be severely negatively impacted if you haven't kept up with your beneficiary desginations. Almost every financial account you have has a beneficiary designation option - including life insurance, retirement accounts, other investment accounts, checking and savings accounts, among others. These beneficiary designations allow you to choose who will receive the assets if you were to die.
For investment accounts the designation is known as TOD (transfer on death) and for bank accounts it is a POD (pay on death). Regardless of what the designation is called, they all act in the same way to transfer the assets to the other person(s) upon your death by operation of law.
Don't Set It and Forget It
If you are like the majority of Americans, you probably set up your beneficiary designations when you first opened the account and have given very little thought to them since. Unfortunately, not properly maintaining the beneficiary designations on your accounts can have disastrous consequences.
If you haven’t reviewed your beneficiary designation on all of your accounts within the last year or two, take time to examine and update each of your accounts. You should also talk with your parents, grandparents, and others loved ones about the importance of them properly designating beneficiaries.
The consequences of ignoring beneficiary designation updates are severe, and often wreak havoc on an estate plan. Improperly set designations will override your will, could increase tax liabilities, and can cause financial difficulties for your heirs.
Beneficiary Designation Override Your Will
Many people spend hours and thousands of dollars having a lawyer draft a will and trust. Unfortunately, many waste all that time and money because they never update the beneficiary designations on their accounts. The law doesn't care about what your will says if beneficiary designations say differently.
Wills govern the distribution of assets in your estate. Beneficiary designations, however, transfer the assets in the account before they ever hit your estate. This means there is nothing left for your will to distribute. The beneficiary designations will always trump your will, and there is nothing a lawyer can do to stop this.
You Can Accidentally Disinherit Your Children
A common mistake with beneficiary designations occurs when couples have more than one child. Often parents are on top of updating beneficiary designations to include the first child. As life and parenthood take more of their time, however, updating beneficiary designations to include future children can easily be forgotten.
Your will may reflect your wishes to leave you estate to your children equally, but any assets without all children as beneficiaries will bypass the will and go solely to the designated children. Other children will be left to the kindness of their siblings to share in the money. When this happens, family fights and even lawsuits ensue.
This problem is magnified when families are mixed families, containing children from previous and current marriages. Children often feel less of a connection to their step siblings, which could result in one set of children over inheriting at the expense of the others.
You Could Accidentally Leave It All To Your Ex
Even worse, not updating your beneficiary designations could result in your entire family being disinherited. If you have an ex-spouse, updating your beneficiary designations becomes vital to ensure your current family receives your assets.
Whoever is listed on the beneficiary designation will receive the assets upon your death. An ex-spouse listed as a beneficiary will get everything, regardless of how long you’ve been divorced or what your will says. People have unintentionally left millions to their ex-spouse because they never changed the beneficiary designations when they divorced or remarried.
Increased Tax Liability
Improperly set beneficiary designations can also cost your heirs significant increases in tax liability. There are both estate and income tax consequences, which could result in much of your money going to your Uncle Sam instead of to your family. The two most common problems occur with improper beneficiary designations on life insurance and retirement accounts.
Increased Estate Tax Liability
With life insurance, if no beneficiary is named (or if the listed beneficiary is already dead) the insurance company will pay the life insurance proceeds to the deceased person’s estate. This means the money in the life insurance policy will go through probate, with all the associated downsides. It also means any estate tax avoidance strategies you may have used when setting up the policy will be threatened.
If properly set up, a life insurance policy can pay your heirs the death benefit completely tax-free. With an improper or lacking beneficiary designation, the proceeds of the life insurance policy will be counted as part of the estate, and the government will take their cut. If your estate is subject to the estate tax, your heirs could lose a significant portion of the life insurance benefit to unnecessary taxes.
Current maximum federal estate taxes are 39.6%, and many states take another 16% in taxes. Assume you have a million dollar insurance policy, which your financial adviser properly set up to avoid estate taxes. You didn’t, however, keep up with the beneficiary changes; so the policy paid your estate the proceeds.
If your estate is subject to taxes, your state could take $160,000 from the proceeds in state inheritance taxes. Then, Uncle Sam will step in and take another $336,000 for estate taxes. leaving a little over $500,000 left. Your heirs will end up receiving just half of the million dollar policy you paid for.
Increased Income Tax Liability
Not having a beneficiary on your IRA, 401 (k), or other qualified retirement account can cause additional tax issues for those you leave behind. When beneficiaries are properly designated, your heirs will have their entire lifetime to take distributions from assets in your retirement accounts. During their lifetime, most of the money will continue to grow tax-free and can be used to fund their retirement.
Without a beneficiary designation, however, your account goes through probate, making the account assets public and taking additional time to distribute assets. Worse, under current tax law, the account now needs to be liquidated within 5 years. When the account is liquidated, your beneficiaries will owe income taxes on the distribution and will lose any tax-free growth they could have benefited from.
Beneficiary Designations Make "After Life" Easier On Your Family
Beneficiary designations pass your assets to your heirs directly, instead of having to go through the probate process. This creates instant liquidity for your heirs so they have cash to pay for expenses. Even with a properly structured will, probate takes time and subjects the assets to the claims of creditors.
Beneficiary designations not only bypass your will but also avoid probate. This means the associated assets will pass quickly and privately to your heirs. This gives your family instant liquidity to be able to pay for funeral expenses, living expenses, and other bills which may come up. Although the probate court has processes for dealing with the problem of your family needing cash, probate takes additional time and effort for your family.
Passing at least some of your checking and savings accounts to your heirs through beneficiary designations will give them access to cash immediately upon your death. All the beneficiary needs to do is present a death certificate to the bank and they will have access to the funds in the accounts.
Joshua Escalante Troesh is a tenured professor of Business at El Camino College and the founder of Purposeful Finance. His career provides him with a unique insight on personal financial, having been a VP at a financial institution leading up to 2008, and involved with technology and internet stock research leading up to 2000. He can be reached for comment at firstname.lastname@example.org