Common Mistakes when Making Beneficiary Designations

Beneficiary designation mistakes prevent assets such as retirement and life insurance accounts from going to the right beneficiaries.

No matter what kind of estate plan you use, your plan can be undone by some common mistakes when making beneficiary designations.  Modern banking and worker economics also means that a lot of your financial value, usually in retirement accounts like IRAs or 401(k)s for example, are governed by beneficiary designations.  That means one mistake affects a huge portion of your financial worth.   Many events make it necessary to review beneficiary designations, as the author in the article “One Beneficiary Mistake You Really Don’t Want to Make” from Kiplinger points out.

Now, there is no definitive guide on how to handle beneficiary designations.  The best solution is to review them with your estate planning attorney to ensure the designations fit your estate plan.  However, this article will cover some common mistakes that can undo even the best of estate plans.  You may also want to review some common estate planning mistakes as they somewhat overlap.  See here for more info:  https://www.galliganmanning.com/what-estate-planning-mistakes-do-people-make/ 

Life Changes.  Any time you experience a life change, including happy events, like marriage, birth or adoption, or unhappy events such as the death or disability of a loved one, you need to review your beneficiary designations.  If there are new people in your life you would like to leave a bequest to, like grandchildren or a charitable organization you want to support as part of your legacy, your beneficiary designations will need to reflect those as well.  A very common and likely very obvious mistake is to not review and update your beneficiary designations after one of those events.

For people who are married, their spouse is usually the primary beneficiary, but do you have a contingent? Beneficiary designations typically have multiple tiers.  The first person to receive is the primary beneficiary.  For married couples, this is typically the other spouse.  However, many clients forget to include contingent beneficiaries to receive if the primary is deceased.  Children are often contingent beneficiaries who receive the proceeds upon death if the primary beneficiary dies before or at the same time that you do.  But, a lack of a beneficiary is a big problem and many companies direct to the proceeds to your estate, which I’m guessing isn’t what you wanted.

It is also wise to notify any insurance company or retirement fund custodian about the death of a primary beneficiary, even if you have properly named contingent beneficiaries, or even better, just update the beneficiary designation to remove the deceased beneficiary’s name.

Not understanding the financial institution’s terms.  Clients often ask what will happen if a named beneficiary of their retirement account dies.  Who does it go to next?  I always have the same answer, what do the account policies say?  For example, let’s say you’re married and have three adult children. The first beneficiary is your spouse, and your three children are contingent beneficiaries. Let’s say Sam has three children, Dolores has no children and James has two children, for a total of five grandchildren.

If both your spouse and James die before you do, all of the proceeds would pass to who?   It could be your two surviving children, and James’ two children would effectively be disinherited. That might not be what you would want. It is also possible that the assets go to the children of the predeceased child.

The difference between these are the difference of what are typically termed per stirpes and per capita.   Some companies allow you to indicate your preference, but not always.   So, you’ll need to speak with the company to better understand how their designations are ruled.

Not incorporating into your estate plan.  Finally, and I made this point briefly in the introduction, you want to coordinate your beneficiary designations and your estate plan.  For example, many clients utilize trusts for their beneficiaries to provide them creditor and divorce protection.  If your life insurance policy goes directly to your child, that money will not receive the creditor and divorce protection the trust affords.  So, arranging the beneficiary designations so that the insurance proceeds will go to that trust protects that money as well.

These are some common mistakes in making beneficiary designations.  Your estate planning attorney will help review all of your assets and means of distribution, so your wishes for your family are clear and effective.

Reference: Kiplinger (March 23, 2021) “One Beneficiary Mistake You Really Don’t Want to Make”

Continue Reading Common Mistakes when Making Beneficiary Designations

The Irrevocable Life Insurance Trust (“ILIT”): Why should you have one?

Irrevocable Life Insurance Trusts, or “ILITs” are irrevocable trusts which own life insurance.  ILITs are used to manage estate taxes by removing the value of the death benefit out of your estate. There are complexities to using an ILIT, but the benefits for some people could be big, according to the article “What Advisors Should Know About Irrevocable Life Insurance Trusts” from U.S. News & World Report.

What is the goal of an ILIT? The goal of an Irrevocable Life Insurance Trust is to own a life insurance policy, so the proceeds of the policy are left to heirs, who avoid estate tax. It’s a type of living trust but one that cannot be dissolved or revoked, unless the trust does not pay premiums and the insurance policy owned by the trust lapses.

The federal estate tax exemption is currently $11.58 million for individuals, and $23.16 for married couples. Most people don’t need to worry about paying federal estate taxes now, but this historically high level will not be around forever. The current law ends in 2025, cutting the exemption by half.  Most experts agree that the exemption will come down well before that time.  See here for another recent article on how to prepare for the estate tax.  https://www.galliganmanning.com/locking-in-a-deceased-spouses-unused-federal-estate-tax-exemption/  

Who needs an ILIT?

The main advantage of an ILIT is providing immediate cash, tax free, to beneficiaries. The value of the ILIT is out of the estate and not subject to taxable estate calculations. The life insurance policy ownership is transferred from the insured to the trust. The insured does not own or control the insurance policy, but this is a small price to pay for the benefits enjoyed by heirs.

ILITs are attractive because there are not many benefits to an individual personally owning life insurance, especially term insurance.  Term life insurance has no cash value, and so is of little importance until death.  However, the death benefit is the amount applicable for estate tax.  So, even though a $2,000,000 term life insurance policy has little to no value during life, that won’t be true for your beneficiaries when they pay estate tax.

The grantor is the insured person, and the policy is purchased with the ILIT as the owner and the beneficiary. The insured cannot be the trustee of the trust. In most cases, the trustee is a family member, and the insurance premiums are paid through annual gifting from the insured to the trust. These are the details that should be explained by an estate planning attorney to maintain the trust’s legitimacy.

If all goes as planned, when the insured dies, the ILIT distributes the life insurance proceeds tax-free to beneficiaries.

How does an ILIT work?

Let’s say that you have assets worth $15 million. You buy a life insurance policy that will pay $5 million to your children. When you die, your taxable estate would be $20 million, which in 2020 would incur about $3.3 million in federal estate taxes. However, if you used an ILIT and the ILIT owned the $5 million policy instead of you, your taxable estate would be $15 million. Your federal estate tax in 2020 would be about $1.3 million. The estate would save $2 million simply by having the ILIT own the $5 million life insurance policy.

What if the estate tax exemption goes down before you die?

If the estate tax exemption goes down and you have already funded the ILIT, it remains safe from estate taxes. Here is another reason to consider an ILIT—as long as the funds remain in the trust, they are safe from beneficiary’s creditors.

Are there any downsides to an ILIT?

ILITs are not do-it-yourself trusts. They are complex and need to be structured so that the annual contributions used to pay the insurance premiums qualify for the $15,000 gift tax exclusion. To do this, an estate planning attorney will often include a “Crummy” power, which allows the insured to pay the trust for the premium, without reducing their lifetime gift tax exemption amount. However, it also means that beneficiaries need to be well-educated about the ILIT, so they don’t make any errors that undo the trust.

When a contribution is made, Crummey letters are sent to the beneficiaries, letting them know that a gift was made to the trust and they have the right to withdraw the money. However, if they withdraw the money, the insurance policy could collapse.

You’ll need to be committed to keeping this policy for the long run. You’ll need to be able to fund it appropriately.

There is also a three year look back for existing insurance policies that are moved into the ILIT, so the grantor must be alive for three years after the policy is given to the ILIT for it to remain outside of the estate. This does not apply when a new policy is established in the ILIT and does not apply if the ILIT buys the policy from the grantor.

Reference: U.S. News & World Report (Oct. 29, 2020) “What Advisors Should Know About Irrevocable Life Insurance Trusts”

Continue Reading The Irrevocable Life Insurance Trust (“ILIT”): Why should you have one?