Today I am going to talk a little about the problems I see with beneficiary selections on both IRAs and Life Insurance. First let's review exactly what a beneficiary is and the goal of our beneficiaries.
The beneficiary provision is supposed to allow for the naming of a primary and contingent beneficiary. The primary beneficiary is the person designated to receive the death benefits if the insured dies. The contingent is the person designated to receive the death benefits if both the insured and the primary die at the same time. Beneficiaries can be a person, a business, or a trust in most cases. An irrevocable beneficiary is a beneficiary who can be changed by the policy holder only with the permission of that beneficiary.
Life Insurance Beneficiary Problems
Many individuals designate their spouse as the primary beneficiary and their children as contingent beneficiaries. There are two problems here. First, the spouse is the primary beneficiary and second the children are the contingent beneficiaries. The thought is, if the husband or wife were to die the money will be passed onto the spouse. If the husband and wife die simultaneously, the benefits will be passed on to the children.
The first problem here is what if the you and your spouse were in some kind of accident where you died first and shortly after your spouse died, may be weeks, days, or hours. Since your spouse did survive you, your contingent beneficiaries are not eligible to receive your benefit. This means the insurance company will pay the proceeds of your policy to their probate estate. Let's say in this accident both the insurance and primary beneficiary both die at the same time. You would think that the benefit would go to the contingent beneficiaries. This is where the second problem starts.
The second problem with this scenario is that children were the contingent beneficiaries. Young children can not be paid life insurance proceeds, with the age varying state by state. This means that if there was no will in place the state would choose who the guardians will be for your surviving children. They may be or not be who you would have chosen had you done your will. As such, death proceeds will be paid to the new guardians of your kids, which means your kids may or may not get the benefit.
Here is your solution. Set up a Uniform Gift to Minors Account (UGMA), a Uniform Transfer to Minors Account (UTMA), or a Trust in the children's name. Both the UGMA and the UTMA are free. With either a UGMA or a UTMA the insurance company will pay the death proceeds into the account. When your children reach age of majority they will then have access to the money. However, most parents would not want their 18 year old child to have access to 500 thousand or 1 million dollars. So, the next best thing is to set up a trust as the primary and contingent beneficiary. This way you as the insured can chose at what age and what amounts money will be distributed to both the primary and contingent beneficiaries. This does cost a little but is the best alternative.
What if you are the only person to die in an accident. Your spouse still may not get the benefit even if they were the primary beneficiary. Here is an example why. Let's say your primary beneficiary received a death benefit of 500,000 dollars. For some reason they latter got remarried. The new spouse after years of begging talks them into buying that dream house on the mountain. Everything is fine at first but for some reason they end up getting a divorce. During the settlements of the divorce the house is given to your surviving beneficiary's ex-spouse. In this example because you put your spouse as the beneficiary, you end up paying your benefit to some stranger you do not know who marries your spouse after your death. How do you feel about that? Solution set up a trust as the primary beneficiary. This way you control the money from the grave.
We did not even talk about other issues such as step parents or kids, special needs beneficiaries, whether to designate beneficiaries as per stirpes or per capita. Every insurance policy should specify one or it is automatically deemed per capita. If you have any questions determining which one you should have call my office. I do not have enough room to explain them here today, I still need to touch on IRA beneficiaries.
IRA beneficiary Problems.
You may be thinking that if a trust is the best selection for your life insurance that it must be good for your IRA's as well. Where there is reason you may want to put your trust as the beneficiary this will in most cases cause more problems. Generally speaking you should never name a trust as the beneficiary of your IRA, even if your attorney tells you to do it. Trusts as IRA beneficiaries create unique problems and tax complications even when executed perfectly. Basically speaking, if the trust fails to qualify as a designated beneficiary, then there is no designated beneficiary, and the trust beneficiary will not be able to stretch post death required distributions even over the surviving spouse's life expectancy. In that case, the IRA will be paid our either under the five-year rule or over the remaining life expectancy of the deceased IRA owner.
I am out of room for today's topic so let me just say there are many more issues to discuss with both life insurance, IRA, or 401 (k) beneficiaries. Hopefully this got you thinking and reviewing what you have. If you have any questions or feel you need a review of your current beneficiary selections or need some ideas what to change please feel free to call my office.