Why Beneficiary Designations Override Your Will
It's critical to review beneficiary designations.
Many people have prior spouses or deceased relatives who are still named as beneficiaries on their retirement accounts or life insurance policies. The problem is that these beneficiary designations are legally binding, and they supersede a last will and testament. The asset will go to the person you named in the beneficiary designation regardless of what your will says.
These beneficiaries might have no idea that they'll receive these accounts or insurance benefits when the policyholder passes on, and they—and the individuals you intended to receive them—could be in for a surprise.
Beneficiary Designations Trump the Will
Many people neglect to update their beneficiary designations after marriage, divorce, or other changes in their family situation. It's easy to forget and some people think an updated will is all they need.
But your will or your living trust won't override the beneficiary designation on a life insurance policy, an annuity, or a retirement account, such as an IRA or 401(k) plan. The beneficiary designation takes precedence.
What if you don't name anyone at all as beneficiary on an IRA account? It will revert to your estate in this case, so your will would take precedence...if you left a will. Otherwise, your state's inheritance laws would get involved.
Update your beneficiary designations to reflect your current wishes so state laws don't determine who receives the benefit.
An Example of Planning Gone Bad
Take the example of a married individual who worked for a large national defense company. It was a second marriage, and this person had a trust drawn up when they learned that they were ill with serious cancer. They wanted their two children from a previous marriage and their current spouse to each get one-third of their assets.
But they didn't update their beneficiary designation with their 401(k) plan, so that entire sizeable account went directly to the spouse. The surviving spouse wanted to honor the deceased's wishes, but they would have had to report all the income on their tax return, plus potentially early distribution penalties, if they cashed in the 401(k) and gave the funds to the deceased's children.
The surviving spouse and children decided to set up an IRA in the spouse's name instead, and roll the funds over into it to avoid a big tax hit. The children would be named as the beneficiaries of the new account and could take distributions from it. They agreed that the spouse would withhold enough to cover the taxes with each distribution that was made. This is legally permissible.
But it would be an ongoing administrative hassle for years. All this could have been avoided if the deceased had updated their retirement plan beneficiary form with their employer.
The employer had no choice but to follow the beneficiary designation form on file. Employers can't change the distribution after death, even if all parties agree to the change.
How to Review Beneficiary Designations
Make a list of each retirement account, life insurance policy, and annuity that you have. Add two additional columns to your list: one for the beneficiary and one for a date. Write down the beneficiary and the date it was last updated for each account or policy.
You should also name a contingent beneficiary in addition to a primary beneficiary. This lets you specify who the account should go to if the primary beneficiary predeceases you.
Keep this list in a binder or file folder along with your other important documents. Make it a habit of pulling this binder out once a year and reviewing the information in it, regardless of any changes.
Contact the company if you need to update a beneficiary. They'll send you a beneficiary designation form that you can fill out, sign, and return to them.
What About a Living Trust?
Many people establish revocable living trusts to govern disposition of their assets, which are titled into the name of the trust after it's formed. You could title bank accounts, investment accounts, and real estate in the name of the trust. You would be the trustee, and you would have complete control over the assets during your lifetime.
The trust document would name a successor trustee to take over management of the trust if you should become incapacitated or die.
A "real person" must be the account owner with an IRA or 401(k), however. You can't re-title an IRA or 401(k) into the name of a trust. You can name the trust as the beneficiary of your IRA, but there can be drawbacks to this approach.
It's best to work with a qualified estate planning attorney to help you figure out the best way to name beneficiaries if you have assets in IRAs and other retirement plans or insurance.