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Naming Beneficiaries Of Insurance Policies And Retirement Plan

A major issue in estate planning is who to name as beneficiaries on life insurance policies, pension plan accounts, and IRAs. Often this important decision is given too little consideration. Naming beneficiaries can be complicated and can present the beneficiary with estate and income tax consequences, as well as benefits.

No matter who is designated, the beneficiaries of a life insurance policy will generally receive the death benefit proceeds federal income tax free. Unlike property disposed of in a will, insurance proceeds do not automatically go through probate.

When Naming Beneficiaries, Remember To Consider

Age of beneficiary — Most policies and plans will not directly transfer assets to minors until a trustee or guardian is approved by a court.
Ability of beneficiary to manage assets— Perhaps a trust set up in the person's name would be more suitable than a direct transfer.
Pension plans — Unless waived by the spouse in writing, the law requires a spouse to be the primary beneficiary of the account.

Name A Spouse Or Create A Trust

For most married individuals with assets under $2.0 million, a spouse will be the most logical beneficiary. A trust may be a prudent beneficiary choice, however, if a surviving spouse would not have the ability to prudently manage a large sum of money. The trustees (often a legal entity rather than an individual) would then take charge of managing, investing, and disbursing the policy proceeds for the benefit of the surviving spouse.

Be sure to name contingent or secondary beneficiaries. This means that if the primary beneficiary predeceases you, the insurance proceeds will go to an individual or trust. Failure to designate a beneficiary often results in the proceeds being directed to the "estate of the insured," which means the death benefits end up being probated and ultimately distributed according to the instructions of the decedent’s last will and testament. If an individual dies without a valid will (intestate), then the order of legal beneficiaries to whom assets are distributed is specified by that state’s law.

Read The Fine Print In Your Pension Plan
The law requires that a spouse be the primary beneficiary of a pension account unless he/she waives that right in writing. A spousal waiver may make sense in a second marriage — if a new spouse is already financially set or if children from a first marriage are more likely to need the money.

Unmarried individuals may name whoever they choose. However, effective in 2007, nonspouse beneficiaries are eligible for a tax-free transfer to an individual retirement account or another pension plan.

In November of 2002, the IRS issued a private-letter ruling that allows companies to amend their retirement plans so that nonspousal beneficiaries can annuitize retirement plan distributions over the life of the beneficiary. Check with your employer to find out if this is an option is available to you. Also, consult a qualified financial professional or tax attorney for additional guidance.

IRAs: Avoiding Taxation

By law, anyone can be named as beneficiary of an IRA. Spouse or non-spousal (effective in 2007) beneficiaries can roll over the death proceeds of the IRA account into an IRA established on their behalf and thus avoid any taxation until withdrawals begin.

The IRS has greatly simplify the calculation of required minimum distributions. Now, upon an IRA owner or plan participant's death, a designated beneficiary may base distributions on his or her life expectancy.

Naming Children May Not Be Best

Naming minor children as beneficiaries may cause unforeseen problems. Generally, insurance companies, pension plans, and retirement accounts will not pay death benefits to minors. The benefits would likely be held until they could be made to a court-approved guardian and/or trustee of a children’s trust. A guardian, trust, or trustee should be named beneficiary to help ensure competent management of the proceeds for the children. By naming a children’s trust as a contingent beneficiary, for example, the proceeds could be invested and managed by a competent trustee (a person or institution) you choose.

Generally, IRAs and Qualified Plans will pass directly to the beneficiary named in the plan document, but if the estate is named as the beneficiary the proceeds will pass through probate.

Special Tax Considerations

Life Insurance — Benefits are generally transferred free of income taxes.

Pension Plans — A nonspouse beneficiary must report the proceeds as "income with respect to a decedent" but can transfer them tax free to an IRA or other pension plan.

Keep Your Plan Current

When completing overall estate plans and wills, it is imperative to readjust all beneficiary designations so that the entire estate plan flows smoothly. Remember, outdated beneficiary designations (i.e., older parents) could misdirect the intended flow of an entire estate plan unless changed now.

Also, beneficiaries are paid directly as named and beneficiary designations can supersede the directions of last wills and testaments. As always in estate planning, every situation is unique. Rely on qualified tax and legal professionals to ensure that you have made the wisest choices.

Points To Remember

Beneficiaries of life insurance policies generally receive the benefits federal income tax free.
A trust may be an appropriate beneficiary in some cases.
Trustees take charge of managing, investing, and disbursing the money for the benefit of the beneficiary(ies).
Be sure to name contingent, or secondary, beneficiaries as well.
The law requires that a spouse must be the primary beneficiary of a pension plan account, unless waived in writing.
Single people can name whoever they wish as beneficiary of a pension plan. Nonspouse beneficiaries must report the proceeds as "income in respect of decedent," but are eligible for a tax-free transfer to an individual retirement account.
Anyone can be named beneficiary of an individual retirement account (IRA). Beneficiaries can roll over death benefits into another tax-deferred IRA.
Minor children may not be the most appropriate beneficiaries. Most insurance policies and retirement plans will not pay benefits to minors without a court-approved guardian or trustee.
Consult with a legal or tax advisor regarding your particular situation.

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(03/07)

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