When we think about estate planning, wills, healthcare documents, powers of attorney, and maybe trusts, come to mind. Those legal documents are important, but, if you’re not careful, an estate plan that includes all of these documents may cover only half of your assets.
How’s that? Many assets that we own are “non-probate” assets – meaning that, upon our deaths, they are distributed outside of our will. This can be a good thing, since, if you pass away, these assets are likely to be distributed to your loved ones in a more timely, less expensive manner than the assets that are processed through a probate court. However, it wreak havoc on an otherwise carefully planned estate if your beneficiary designations are out of date.
The two most common non-probate assets are life insurance policies and tax-deferred retirement accounts, such as 401(k) accounts or IRAs. Outside of our home, these assets often make up the largest part of our net worth. If the beneficiary designations for these assets are incorrect, the better part of your estate may not end up in the right hands.
Failing to Keep Your Beneficiary Designations Up-To-Date
When you first created your retirement account, you may have named your best friend. Now, 10 years later, you’re married, have two kids, and haven’t talked to your “friend” in two years. Even if you’ve since executed a will leaving all of your assets to your spouse and children, the money in your retirement account will end up with your former friend if something happened to you.
Not Removing Your Former Spouse – ASAP!
Out-of-date beneficiary designations can be a particularly nasty trap for divorced parents. Under most state laws, former spouses are automatically removed from wills, powers of attorney, and healthcare proxies – which makes sense. Very few people would want their ex-wife or ex-husband deciding whether to pull the plug in a life or death situation. For most life insurance policies, divorce invalidates a former spouse named as a beneficiary as well.
Unfortunately, retirement accounts are a different story. Beneficiary designations naming former spouses continue to be valid long after the divorce is finalized. While most states have passed laws invalidating such designations, those laws are currently overridden by federal laws. You can expect a fix to this problem at some point in the future, but in the meantime, make sure to change the beneficiary designation on your retirement accounts if you’ve recently divorced, or in the process of getting divorced.
Naming Your Kids as Beneficiaries
You might assume that you should name your kids as beneficiaries – since you want to provide for them if something happened to you. However, an insurance company or a retirement plan administrator will generally not make a check out to a child who is under the age of 18, so a guardian must be appointed by the court to oversee the assets. This creates an annual reporting requirement for the court-appointed guardian (usually a family member), who must account for how the assets are held and report on how the money is being spent. These reports can become a matter of public record, available to identity thieves and predators.
In order to avoid court supervision, you can name a custodian to administer the assets for your child until they turn 18. Alternatively, you can name a trust as the beneficiary of your life insurance proceeds or a special type of trust (described below) for retirement accounts. If you have set up a will with a testamentary trust, you can name your estate as the beneficiary of your life insurance proceeds in order to make sure that the money receives the protection of the trust.
Naming a Trust as a Beneficiary of Your Retirement Accounts
While leaving your assets, including your non-probate assets, to a trust for the benefit of your kids is generally a good idea, naming a trust or your estate as the beneficiary of a retirement account can be a big mistake, resulting in a large tax bill for your family.
If your children are under the age of 18, you should name either a custodian to hold the assets for the benefit of your child or a trust that is specifically designed to hold tax-deferred retirement accounts. Consult with a financial advisor or an estate planning attorney to ensure the beneficiary designations for your retirement accounts will not trigger unnecessary income taxes.
Not Incorporating Beneficiary Designations into a Comprehensive Estate Plan
In order to ensure that your assets would go to the people you want to have them, it is important to create a comprehensive estate plan that incorporates not just your legal documents, but also your beneficiary designations. Creating a comprehensive plan with a an estate planning lawyer and financial advisor can ensure that your family would be taken care of if something happened to you. Reviewing your plan regularly will ensure that your plan addresses changed circumstances or unexpected events.