Estate planning is a broad term that describes the process of directing what happens to your assets upon your death. The process may entail additional directions or stipulations to be observed and often involves planning to minimize the tax burden on your heirs, but primarily deals with how and what you wish to pass on when you pass on.
The core of an estate plan typically includes a will, which must generally be executed through a process known as probate. Depending upon the complexity and value of the estate, probate can be costly and sometimes lengthy. However, certain types of accounts or assets can be transmitted directly by naming one or more beneficiaries, avoiding probate and bypassing the will.
Naming, and importantly, maintaining beneficiary designations can expedite the transfer to heirs and minimize the chance of unwanted outcomes. So, what is a beneficiary, and what happens if no one is named?
As early as the 18th century, proceeds from life insurance policies became payable to the person or entity named in the policy rather than into the estate of the deceased. Subsequent court cases held that an insurance policy was a contract that operated separately and apart from the other assets in an estate. That is to say that death benefits passed by operation of contract law rather than through the probate process. A major shift occurred in 1974 with the passage of the landmark Employee Retirement Income Security Act of 1974 that extended the concept of designating specific beneficiaries to retirement plan assets.
Retirement accounts including IRAs and defined contribution plans like 401(k) and 403(b) plans allow the account holder to name one or more beneficiaries to inherit the account assets when the owner dies. Upon notification and provision of sufficient documentation, the beneficiaries receive the assets directly, bypassing the will and avoiding the probate process.
In most cases, a retirement account owner designates a spouse, children, or other family members to receive the assets. Spouses may choose to treat the inherited account as if it was their own and even combine it with their own account of the same type if they have one. Non spouses are subject to specific rules regarding required distributions and tax treatment that depend upon the age of the original owner and whether they had begun taking mandatory distributions.
There are 2 classes of beneficiary. A primary beneficiary is the first in line to receive the decedent’s assets upon death. Any number of primary beneficiaries can be designated to receive any share of the assets the owner specifies. In addition to spouses or other people, a beneficiary may be a charity, trust, or even the owner’s estate if other planning considerations warrant.
A contingent beneficiary is a second line heir that can be designated to receive the assets if the primary designee predeceases the owner. As with the primary, any number may be named to receive any share. Any or all beneficiary designations may be revised or changed by the account holder at any time prior to their death. Note however that in 9 U.S. states, the law dictates that a spouse is entitled to 50% of retirement assets, and consent of the spouse is required to name someone else as beneficiary. Tennessee and Georgia do not require spousal consent.
While it is simple to name beneficiaries, it can also be easy to create unintended consequences if circumstances change. For example, in the case of divorce and remarriage, it is not uncommon for the owner to forget to change the beneficiary. Guess who gets the money. Other life events like the birth of additional children or grandchildren, or the death or divorce of beneficiaries are important reasons to review all estate planning documents including beneficiary designations. Making changes is generally as simple as filing a new form.
The utility of naming beneficiaries on specific accounts extends far beyond IRA and 401(k) retirement accounts. In most states, a bank account can be titled to include a Payable on Death designation, allowing the assets in the account to pass directly to named beneficiaries outside the will and probate process. Brokerage accounts can usually include a similar designation called Transfer of Death to pass stocks and bond investments directly to named recipients. In some states (although not Tennessee), homeowners can specify a Transfer of Death in their title, also known as a beneficiary deed.
Note that state laws vary regarding these designations, and it is important to consult with an estate planning professional to make sure these decisions comport with the overall plan, as the situation can get complex.
While naming a beneficiary is a simple and powerful planning tool, what happens if you fail to do so or decide not to? In that event, things may get complicated. Each retirement account custodian (brokerage firms or banks) defines default options within the account application or contract. Often but not always, the spouse stands next in line. In some cases, or if there is no surviving spouse, the assets pass into the owner’s estate, which subjects them to probate and typically forecloses the tax deferral options that would be available to named beneficiaries. And if there is no will in force, each state decides who gets the money according to their own laws.
According to the Investment Company Institute, a massive intergenerational transfer is in process, with $14 trillion in defined contribution plans like 401(k)s and over $19 trillion in IRA accounts in the U.S. that will eventually pass to heirs. Current owners of these assets have a simple but powerful tool to transfer those trillions to the next generation in the most tax efficient and cost effective manner with a simple signature. It could be time to review your plans with a financial professional to make sure your wishes are carried out.