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Beneficiary Designations: Do's and Don'ts

How you handle the beneficiary designations on your life insurance and retirement accounts can be just as important as naming the beneficiaries of your probate estate in Money and Home with Family on a Balance Scaleyour last will and testament. I call them non-probate assets. In the hundreds of estate planning worksheets I have received from clients in the past few years I have identified a common pattern. About half the family wealth passing to the next generation in the event of a death with no surviving spouse are the non-probate assets.

For discussion purposes let’s address the hypothetical couple with one or more children under 25 years of age. Often that couple will have no less than $500,000 of life insurance coverage through a combination of the group term policies from their employers and the individual policies they own. If they have been prudent, or fortunate enough to have a generous 401(k) plan at work, there might be another $200,000 in retirement accounts. With equity in their home, some stock investments and cash, this couple could be “worth” about a million dollars in the event of both of them dying, either simultaneously or sequentially. Let’s also assume that they have been prudent enough to get wills drawn up when the children were younger.

Unfortunately, they have been too busy with everyday life to revisit the subject of their wills and estate plan. The wills are now more than ten years old. In the intervening years those non-probate assets built up without much thought as to how they relate to the provisions in their wills. Ideally they have a contingent trust in those wills that will be established in the event that there is no surviving spouse and there are children living. But how will all those non-probate assets get into that contingent trust?

The answer is the secondary beneficiary designation. Usually that designation will specify the trust established by the insured’s last will and testament. That is called a testamentary trust. Sometimes it will be a trust established by a separate document (often called a “living trust”).The person named as trustee obtains the payment of the life insurance and retirement account, but only if the trust is designated as the secondary beneficiary.

In Georgia a testamentary trust is fairly common because Georgia’s probate system is very user friendly. However, sometimes it can be appropriate to write a revocable trust (a “living trust”) instead of a testamentary trust. Then the secondary beneficiary for John A. Client could be the Trustee of the John A. Client Family Trust, under agreement dated 12/1/2020.

Someone who does not have a trust for young children might be tempted to put them down as the secondary beneficiaries of the life insurance. That is not a good idea. If the death benefit from life insurance is payable to someone who is under 18 years of age, the company will insist on paying it to a court-appointed conservator of the property. The legal costs and the premiums for the surety bond required for any court appointed conservator can be considerable. Once the child attains 18 years of age, the entire death benefit must be turned over to the child. In the meantime, without permission from the probate court, the conservator can only invest the trust’s assets in bank accounts, certificates of deposit and state/federal government bonds.

It’s far better if the death benefit is held in a trust. The terms of the trust can require the trustee to use the money for the child’s care, education and support. Investments by a trustee are governed by the reasonable prudent investor rules. The trust assets can be invested in stocks, bonds and financial instruments. Individuals serving as trustee can engage an investment advisor to design and manage an investment portfolio.

The trust provisions can delay the ultimate distribution of all the assets to the child until a time when the parent believes the child is going to be responsible. In the worst case scenario the trust will continue to operate during the entire lifetime of the child.

Finally, there can be complicated income tax issues when the trust is named as the secondary beneficiary of a retirement account (with the spouse as primary). Special trust provisions should instruct the trustee to comply with the tax code’s requirements for distributions from the trust to the beneficiary after the death of an account holder. It’s a complicated subject deserving a separate blog post. Suffice it to say that boilerplate trust provisions are unlikely to even mention the tax angles.

The job is not done until the legal documents have suitable beneficiary designations so that both probate and non-probate assets will end up controlled by the plan embodied in those documents.