When it comes to estate planning, a will or a trust often receives the most attention. However, the simple act of naming a beneficiary to inherit assets in your 401(k), IRA, or savings account, or the proceeds of a life insurance policy or annuity, is a powerful estate planning tool.
“Some folks minimize the importance of a beneficiary designation,” said Rachelle Tubongbanua, a private wealth advisor and managing director at U.S. Bank.
But that’s an estate planning mistake.
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Choosing and properly designating a beneficiary is a key step in making sure your assets go to the person or people you want them to go to. A beneficiary is the person or entity who will get your assets when you die.
It's not a game of "duck, duck, goose," where any heir can "win" an inheritance; it requires careful thought about who gets what.
Two Keys to Naming a Beneficiary
There are two often overlooked benefits of naming a beneficiary. A beneficiary designation supersedes instructions in a will and trust, meaning the assets will be distributed directly to the named beneficiaries. The other major benefit is that assets are typically distributed to whomever you name as beneficiary without having to go through the costly and time-consuming probate process. Probate is a legal process for distributing the deceased person's assets.
“A beneficiary designation is going to trump anything else that you may have established to pass on assets,” said Sarah Mouser, managing director of financial planning at Verdence Capital Advisors.
And if you forget to name a beneficiary for your retirement account or life policy — or simply don’t get around to it?
“You’re going to go through the probate process,” said Mouser. (Your assets are) going to be tied up. It's going to take longer for those assets to get to who they need to get to. And there's no guarantee that they’re going to pass the way you want them to pass.”
Unfortunately, some clients push off filling out their 401(k) beneficiary forms online when they take a new job, Tubongbanua says. Often they hold off because they don’t have key information at their fingertips,
“They say, ‘let me just wait till next time on log on to add those beneficiary designations,” said Tubongbanua. The problem with such delays is “if a life event such as (the asset owner’s death) were to happen and there’s not a beneficiary designation in place, these assets may go to probate.”
So, whom should you name as your primary beneficiary or your contingent (e.g., secondary) beneficiary in the event your primary beneficiary is not alive at the time of your death?
That’s a personal decision, of course. But beneficiaries are typically your loved ones, such as your spouse, children and grandchildren. Pick who you want your assets to go to after you’re gone.
Six pitfalls to avoid when designating a beneficiary
There are steps you can take – and mistakes you can avoid – to make 100% sure your wishes are met.
Here are six pitfalls to avoid.
1. Not naming a beneficiary
Choosing a beneficiary and making your designation official is easy. There’s no defensible reason not to do so. So, if you get a new job and open a new 401(k) or buy a life insurance policy, do the right thing and take the time to provide your beneficiary's (and contingent beneficiaries') correct legal name and date of birth, as well as any other requested identification such as mailing address, phone number, e-mail address, or Social Security number.
Don't assume that naming a beneficiary in your will is sufficient. If there are no named beneficiaries to, say, a 401(k) or life insurance policy, the proceeds will go to the deceased’s estate and through probate.
And that complicates things and adds uncertainty to how your estate will be settled.
“If there's not a beneficiary designation in place, and those assets do go through probate, that's where it opens up the doors right for those assets to be disputed,” said Tubongbanua.
The legal cost of probate will likely reduce the dollar amount of assets that eventually go to your beneficiaries.
2. Failing to update beneficiary forms after a life event
Big life changes, such as divorce, marriage, or adding a newborn to the family, are good times to ensure all your beneficiary designations are up to date, current, and clearly state your wishes as to who you want your assets to go to. Unless you experience a major life event, financial advisors recommend reviewing your beneficiary designations annually.
The risk of not updating your beneficiaries after a life event is money inadvertently falling into the wrong hands, says Mouser.
“A common pitfall I see is treating beneficiary designations as ‘set and forget,’ ” said Mouser. “People often name a spouse, child, or parent and then never revisit it.”
This snafu often occurs post-divorce. Mouser recalls a late client who had gotten a divorce but never changed or updated the beneficiary on an old life insurance policy that was still in effect at his death. That error cost his second wife, who got zero of the proceeds.
“The client’s beneficiary designation was never updated, and the beneficiary remained the ex-spouse,” Mouser recalled. “All those assets went to her because a beneficiary designation trumps a will” and other estate planning documents.
If you think beneficiary designations are automatically updated after a life change, think again, says Mouser.
“A lot of people just don't think to go back through and update beneficiary designations, especially if they've gone through the efforts of working with an attorney to draft an estate plan,” said Mouser. “They think it's automatically updated, but it’s not.”
3. Naming a minor child as a primary or contingent behavior
The reason not to do this is simple: minors are not of legal age and, therefore, can’t inherit money. As a result, even though the child is named as a beneficiary, a court-appointed guardian will oversee the money until the child becomes an adult, which can be costly, says Tubongbanua.
The "age of majority," when young people are considered adults and can inherit, is 18 in most U.S. states. In Nebraska and Alabama, the age of majority is 19, and it is 21 in Mississippi. If your child is aged 18 to 20, you should also review your state's rules for delaying their inheritance until 21 or later.
It’s also prudent to inform any beneficiaries that they will receive assets upon your death, and to give them an idea of what to expect when attempting to claim the assets, says Tubongbanua.
“We tell our clients to make sure that they’re having family meetings where they can kind of guide the beneficiary through the process and what to expect,” said Tubongbanua. “You don't have to share all the great details (such as dollar amounts), but at least give them some sense of preparation so when that triggering event does happen, they're not caught off-guard.”
4. Failing to name a contingent beneficiary
In the event a primary beneficiary passes away, it’s important to name a contingent beneficiary, such as adult children, to ensure there’s a clear path to inherit, says Mouser. Say you’re married and have two adult children. You could name your spouse as the primary beneficiary, getting 100% of your assets, and designate both of your adult kids as contingent beneficiaries, noting that they will split assets 50/50.
“You should always list a contingent beneficiary,” said Mouser. “You never know what could happen. Listing a contingent beneficiary is really important to avoid probate.”
5. Forgetting to name grandchildren
Families often want to preserve wealth across multiple generations. However, if beneficiary designations only go to children, the grandchildren may miss out on so-called generation-skipping trust-tax-efficient structures, such as dynasty trusts, says Mouser.
6. Overlooking charitable intentions
Tax-deferred IRAs and retirement accounts are highly tax-inefficient to leave to individuals. “But they are ideal (to leave) for charities, since charities don’t pay income tax,” said Mouser. “Many wealthy families miss this opportunity and leave after-tax assets to charity instead, reducing tax efficiency.”
Make a graceful exit
Ensure you consider tax implications when naming beneficiaries.
“You may miss tax-savings opportunities based on how you structure your beneficiary designations,” said Mouser.
When it comes to your estate, making sure you get your beneficiary designations right is just as important as constructing he proper investment portfolio during the accumulation stage of your nest egg, says Mouser.
It’s also important to make sure that beneficiary designations align with your carefully crafted estate plan, adds Mouser.
“You can go through the process of drafting all these documents, and if you don't go through the exercise of updating those beneficiaries where those assets are held, then they're not going to align with the trust (or other estate-planning documents, said Mouser.
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