A beneficiary is a person or entity that derives something of advantage from something else or someone else1. A beneficiary may be chosen and designated in advance such as in a Will, trust, retirement account or life insurance policy. Sometimes, beneficiary status may be serendipitously and passively achieved such as from tax law change1.
Beneficiaries may be classified in a few different ways. It is important to become familiar with the classifications and the associated jargon to correctly speak the language of beneficiary designations. Some common examples may include the following:
· A primary beneficiary is the person or entity that is first in line to receive a benefit2.
· A contingent beneficiary is a person or entity that is next in line to receive the benefit if the primary beneficiary either cannot or will not receive it2. There may be multiple succeeding contingent beneficiaries who may benefit in a specific order if the immediately prior contingent beneficiary cannot or will not accept the benefit.
· Multiple primary beneficiaries may share in the same benefit. Similarly, multiple contingent beneficiaries may share in the same benefit. The sharing may be equal or divided in some other way. Beneficiaries sharing in the same benefit may be referred to as co-beneficiaries3.
· When selecting and designating a beneficiary (primary or contingent), some Latin words are frequently used to describe how assets are to be divided:
o A per capita (“per head”) distribution generally describes an arrangement where the assets would be split equally among the surviving beneficiaries next in line in the class of beneficiaries designated to inherit. For example, you leave your life insurance proceeds in equal shares per capita to your three children, but one child predeceases you. The insurance proceeds would be divided between the two surviving children13.
o A per stirpes (“per branch” or “per root”) distribution using the above example would distribute assets equally among the three “branches” of your offspring. Let’s assume the predeceased child left children of her own (your grandchildren). The grandchildren in the predeceased child’s branch would share equally in that branch’s 1/3 share13.
· In connection with the Secure Act, legal terms of art such as “designated beneficiaries” and “eligible designated beneficiaries” have been defined:
o A designated beneficiary is any individual (as opposed to an entity) named as the beneficiary of an IRA or retirement plan4;
o An eligible designated beneficiary is a designated beneficiary that is the account holder’s spouse or minor child, a disabled or chronically ill individual, or one who is less than 10 years younger than the account holder4.
· An income beneficiary refers to a person or entity who is the beneficiary of the income, generally from a trust, however that trust defines income.
· A remainder beneficiary generally refers to the beneficiary of the interest remaining after the income beneficiary’s interest ends14.
· We’ve seen some confusion over the use of the term successor beneficiary often confusing it with contingent beneficiary. A successorbeneficiary is simply the beneficiary of a beneficiary and as a specific term of art arises after an IRA has already been inherited by its beneficiary. Unlike contingent beneficiaries, there are special distribution rules for these successor beneficiaries5.
All of the above examples of types of beneficiaries and their interests have specific rules about how they work and how they may be used. Although the details of those rules could fill textbooks (and they have), they are beyond the scope of this discussion. However, they are important and should engender some questions for your financial advisor or they should be a reason for you to find an advisor if you don’t have one.
Once the desired beneficiaries have been chosen, whether in an annuity or insurance contract, in a Will or a trust or in an investment or retirement account: (1) it becomes important to understand what assets are affected by each designation; and (2) it is important to coordinate the beneficiary designations to work together to achieve the intended overall asset distribution goal with income tax sensitivity.
Your Will may state that your entire probate estate passes to your spouse. But insurance, investment and retirement accounts with beneficiary designations may pass by beneficiary designation outside of your probate estate. Therefore, they are not impacted by the beneficiary designations made in your Will6. You may have both retirement assets and non-retirement assets. Retirement and non-retirement assets may be subject to different income tax consequences. Therefore, some beneficiary decisions could have income tax implications, such as considering which assets to leave to a charitable entity or to heirs in high or low tax brackets.
When naming a beneficiary, it is important that the beneficiary be clearly identified, possibly including Social Security numbers. This can help reduce disputes, especially where names may be similar.
What if you don’t name a beneficiary on your life insurance policy? How will the assets be distributed?
Some life insurance companies may have specific guidelines to deal with cases where there is no beneficiary by imposing a default order of payment. Each company needs to be queried on this if the occasion arises. If the particular company has no such default order of payment, then payment may be to the policyowner (if the policyowner is a different person than the insured) or to the policyowner’s probate estate7. The lack of a beneficiary designation can elongate the timeframe to begin and complete the payout process.
Other examples of life insurance beneficiary issues may when:
· The beneficiary and the insured die at the same time or in a manner where their order of death cannot be determined and there’s no contingent beneficiary; or
· The beneficiary predeceases the insured and there’s no contingent beneficiary9.
Assets passing by beneficiary designation generally by-pass the probate process and pass automatically on death to the named beneficiary. Insurance proceeds which become part of the probate estate, either because the estate was named as a beneficiary, or because no beneficiary was named, may be subject to Probate Court oversight and fees and claims of the policyowner’s creditors. In addition, if there’s a Will, these assets may end up passing pursuant to the instructions in the Will, which may not have been what was originally intended for the policy proceeds.
What if the decedent dies intestate - without a Will? There’s still a probate estate, but the asset distribution scheme is now determined by state law. For example, the New York Estates, Powers and Trusts Law (EPTL) §4-1.1 sets forth New York State’s order of distribution. If the decedent left a spouse and children, there will be a division of estate assets between the spouse and the children. This asset division might not have been intended or anticipated8. Some may assume that the surviving spouse would receive the entire estate.
What if you don’t name a beneficiary on your retirement account?
The plan documents for the retirement account may determine who a default beneficiary might be. Often it is the decedent’s estate or the surviving spouse. An inadvertent missing beneficiary designation may occur where the retirement account is moved to another provider without completing a new beneficiary designation form10. With respect to a 401(k) ERISA plan, Fidelity states that a plan with no beneficiary automatically is inherited by the spouse11.
If the account owner’s estate is the designated or default IRA beneficiary, the IRA becomes subject to the probate process instead of avoiding it by through making a specific beneficiary designation to a person. Under some conditions, complete account payout (and taxation) may be required within five years12. In addition, as part of the probate estate, these plan assets which may have been imbued with some asset protection, now may be subject to the claims of the decedent’s creditors. Additionally, these assets may pass in a manner different from what was originally intended.
From the foregoing discussion, it is clear that choosing and designating beneficiaries to achieve a coordinated, tax-sensitive post-mortem asset distribution goal may be a complex task. The rules surrounding beneficiary designations may differ depending on whether Wills, trusts, insurance, bank, investment or retirement accounts are being considered. Adding to the complexity is the fact that as life changes, beneficiary designations may need to change as well.
The bottom line: regular review of your beneficiary designations as part of a regular financial and estate planning review is prudent.
The Family Wealth Decisions Group makes it a practice to periodically review the currency of beneficiary designations for its clients. Please contact us for a complimentary 30 minute consultation to talk about your beneficiary designations.
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1. https://www.merriam-webster.com/dictionary/beneficiary
2. https://www.legalzoom.com/articles/contingent-beneficiary-vs-primary-beneficiary
3. https://www.vocabulary.com/dictionary/co-beneficiary
4. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary
5. https://greenleaftrust.com/missives/successor-beneficiaries/
6. https://www.edelmanfinancialengines.com/education/estate/beneficiary-designation-vs-will
7. https://www.aflac.com/resources/life-insurance/life-insurance-with-no-beneficiary.aspx
10. https://www.actec.org/resource-center/video/common-ira-beneficiary-scenarios/
11. https://www.fidelity.com/learning-center/smart-money/what-happens-to-401k-when-you-die
12. https://www.wbny.com/Secure-Act-rules-ira-beneficiary
14. https://www.accountingtools.com/articles/remainder-beneficiary
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