Your beneficiary designations are probably the single greatest estate planning tool you have available (other than a living trust). Yet very few people take the time to make informed decisions. Here’s a run-down of the top 5 traps and how to avoid them.
1. Different Rules
Beneficiary designations are important. But IRA beneficiary rules are different from life insurance, annuities and individual account rules. Each of these financial instruments have different rules. For example, retirement accounts allow your beneficiaries to continue deferring the tax on some or most of your retirement accounts. The best use of that tax deferral would be for the youngest beneficiary to be left that money (if there is no sp0use). Life insurance doesn’t involve income tax (if held properly) but if you name the wrong beneficiary, it could needlessly mess up your estate tax situation. You might even consider creating an irrevocable life insurance trust to protect that money and the beneficiaries.
Make sure you are clear on what your objectives are with each pot of money and make sure you understand the rules that govern each investment vehicle before selecting your beneficiaries.
2. No Rules of Thumb
You may have heard a rule of thumb that you should always name your spouse as the beneficiary of your retirement account. Wrong. What if he doesn’t need the money? What if you don’t trust him to take care of the kids once you’re gone? What if…….. (you fill in the blanks). What if it’s a Roth….how do you select the right Roth IRA beneficiary?
Rules of thumb are very dangerous when it comes to beneficiary designations for two reasons. First, your situation is unique. No two people have the same exact circumstances so don’t oversimplify by accepting some rule of thumb and end up shooting yourself in the foot. The second reason why rules of thumb are dangerous is because the real rules change faster than the rules of thumb do. You may get some wisenheimer advice that may have actually been true – if it weren’t for the fact the rules changed last year. I’ve seen that happen time and time again.
3. Expecting Too Much from your Advisor
The third error that people make when it comes to their beneficiary designations is expecting their financial advisor, tax consultant, or stock broker to tell them how to name a beneficiary. And don’t expect that IRA custodians will worry about this either. First, many of these people aren’t trained in these issues. They don’t all have the experience and education so they aren’t qualified to help you. And even if they do know it, they’ll often fail to bring up the subject. They don’t want the liability. Don’t wait for them to alert you. You must ask these questions – and I strongly advise you to speak with your attorney anyway.
4. No Updating
Beneficiary designation is clearly not a “set it and forget it” activity. The laws change and so do your circumstances. For example, over the last 4 years, the estate tax rules have changed every year in a major way. The plans you set in place even last year may no longer be to your advantage. Speak with your attorney about updating your beneficiary designations now.
Everyone wants to be fair to their beneficiaries but it’s far easier said than done. First, no matter what you do, somebody is going to feel left out or not being treated well. Even though you love your children equally, sometimes they don’t all need or deserve an equal share. If you have one child who is a wealthy small business owner and the other an unemployed electrician, are you really going to split that inheritance down the middle? The business owner may not need your money but for the electrician, it could save him. What is fair? It’s not an easy decision.
6. No Communication
Tied in to the issue of fairness is communication. Of course, it would be easier to name the beneficiaries and keep it secret until you die. That way, you won’t get any grief about it. That’s certainly the easiest route to take. Of course, that would mean that if you made one of the errors I’ve named so far, it will be too late to correct it. And your version of “fair” and your beneficiaries’ version of “fair” may differ. That could lead to an irreparable split in the family.
Don’t take the easy way out. Talk about what you’re doing now with everyone involved. Don’t make a mess that your loved ones will later have to clean up.
7. Giving Too Much Too Fast
I’ve seen a number of situations where too much thought is given to the beneficiaries are too little attention is given to the donor. If you are married, do some financial planning and projections. Of course it won’t be perfect because nobody can predict the future. But please don’t leave your kids all the money when in fact your spouse will need it.
Nobody knows how long they’re going to live. Nobody knows how our investments are going to do in the short run or what the rules will be. That’s why you must re-evaluate your beneficiary designations every year or two.
When was the last time you reviewed your beneficiary designations? Did you discover anything you needed to change? What was it?