As part of a recent series, I wrote an article about various issues involved with making sure beneficiary designations on such matters as Individual Retirement Accounts (IRAs), 401(k) accounts, life insurance policies and other similar retirement benefit accounts. Since writing the original article, I have encountered at least three different situations with respect to new clients where the beneficiary designations that were made by an individual during his/her lifetime were not changed after a significant event like the death of a spouse or a divorce, which eventually led to an unintended consequence of individuals receiving proceeds as a beneficiary who the descendant would not have wanted to receive the proceeds.
As a result, I think it is worth revisiting the issue of various common mistakes that individuals make when naming beneficiaries on life insurance policies or retirement-type assets/accounts.
Naming beneficiaries of an insurance policy seems like an easy thing to do. If a person is married, the spouse is the beneficiary, and the children are often named as the contingent beneficiaries. If a person is not married but has children, the children are often named as primary beneficiaries. Usually these are the people that life insurance is intended to benefit; however, without knowing or considering the consequences of the beneficiary designation, the policyholder’s intended goals may be thwarted. The following are the top five mistakes people make when naming a beneficiary of an insurance policy or retirement-type asset/account:
- Failing to Update Beneficiary Designation. The beneficiary named when a policy is first obtained may not be the appropriate beneficiary at a later date. It is important to update the beneficiary designation on a regular basis to reflect changes in life circumstances, not only for the policyholder but for the named beneficiaries. Beneficiary designations should be reviewed every two to three years and upon important life events like births, deaths, divorces and significant changes in asset makeup.
- Not Naming a Contingent Beneficiary. Many individuals only name one person as a beneficiary of a life insurance policy or retirement asset, assuming he or she will outlive the beneficiary. However, if the individual policyholder or retirement account owner does not outlive the beneficiary and did not update the beneficiary designation, the proceeds would be subject to probate at the policyholder’s death. In many states, probate is expensive and time-consuming. The failure to name a contingent beneficiary will result in the policy proceeds being used for probate court and attorney fees instead of going directly to your beneficiary. An unintended consequence of the probate may be that the ultimate beneficiary of the proceeds of the life insurance policy or retirement asset (i.e., the beneficiary of the probate estate) is a minor child or person receiving needs-based government benefits. Ultimately an individual receiving government assistance could be disqualified from those benefits by the proceeds received as a beneficiary. These consequences can be avoided with planning. It is important to name contingent beneficiaries and update the beneficiaries often.
- Naming a Minor as a Beneficiary. Parents, especially single parents, obtain life insurance to provide for their children in case they die before the children are grown and finished with school. But naming the child as a beneficiary is a mistake. In many states, naming a minor as a beneficiary of a life insurance policy, either directly or indirectly, because the policy was subject to probate, will subject the life insurance proceeds to a court-ordered guardianship of the estate for the minor child. Not only will thousands of dollars be wasted in court and attorney fees due to the guardianship procedure and bi-annual accountings that must be provided to the court, upon obtaining 18 years, the child is entitled to receive the full balance of the policy proceeds. At that age, even the most responsible individuals will be overwhelmed with inheriting a large amount of cash, and many don’t end up using the proceeds as a deceased parent intended. The solution is to leave the proceeds in a trust for the benefit of a minor child. This allows the policyholder to control how the policy proceeds are used and at what age the beneficiary has access to the proceeds without either court supervision or supervision of a successor trustee who is named by the deceased parent prior to his or her death.
- Naming a Beneficiary Who Receives Needs-Based Government Benefits. Naming a person with special needs who receives needs-based government benefits as a beneficiary of a life insurance policy may cause the beneficiary to lose his/her government benefits. If the policyholder wants to provide for the special needs of this person, creating a special needs trust and naming the special needs trust as the beneficiary can protect the assets for the beneficiary and keep the beneficiary eligible to continue to receive the needs-based government assistance. The proceeds in the trust are used to supplement the government benefits instead of eliminating them. Creating the trust with the special needs person as a beneficiary also eliminates gifting issues and family conflict issues that often occur when a sibling or other family member is named as a beneficiary of a life insurance policy whose proceeds are intended to be used for the person with special needs.
- Assuming a Trust Controls Insurance Policy Beneficiary Designation. Many people create living trusts and assume their estate plan, including the distribution of insurance proceeds, is taken care of. This is wrong. The life insurance policy beneficiary designation controls where the money is distributed, not the trust. To ensure that the life insurance proceeds become part of the trust and are distributed in accordance with the provisions of the trust, the trust needs to be named as the beneficiary of the life insurance policy.
If there is one thought to be remembered from the above-referenced information, it would be the importance of reviewing your beneficiary designations every couple of years to make sure they match your intent with respect to how proceeds would be distributed to an individual beneficiary from either a life insurance policy or retirement account in the event of your death. A regular review of your beneficiary designations will avoid unintended consequences where proceeds are distributed to individuals who may not be the preferred beneficiaries of the proceeds that they receive.