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Beneficiary Designations as Estate Planning Tools

Beneficiary Designations as Estate Planning Tools

Estate planning can be complicated, especially if there is a large amount of assets involved. Indeed, the array of distribution plans available to help you provide for your heirs, minimize taxes, sustain investment growth potential and meet legacy goals can make the process all the more complex. Beneficiary designations can help simplify the estate planning process.

Beneficiary designations are essential for life insurance, annuities and qualified and non-qualified deferred compensation plans. "There are many benefits to using beneficiary designations to transfer wealth to your heirs," says Dianna Parker, CFP, a national resource on Estate and Business Planning.

Designations Can Affect Tax Liability
When you use a beneficiary designation to transfer wealth, the assets can pass directly to the individual beneficiary immediately and avoid court probate, which is a costly and time-consuming process in some states. However, if you don't designate a beneficiary, you can compromise non-probate assets by having them roll into your estate and therefore be exposed to probate. In addition, you can use beneficiary designations to potentially defer income taxes and increase the value of the inheritance, says Parker.

It's also advisable to speak to your financial planner about the benefits of a multi-generational distribution strategy by "stretching" your IRA account by naming primary and contingent beneficiaries and taking required minimum distributions. A stretch IRA strategy enables you to pass an IRA account to a spouse, child or to multi-generational beneficiaries. The process can help maximize the account's growth potential through compounding and deferring taxes over a beneficiary's lifetime.

With a stretch IRA, if you have $1 million in a qualified IRA plan and name your spouse as a beneficiary, he or she can roll over the full amount into an account that continues tax-deferred. However, naming another individual as the beneficiary can trigger income tax liability on the account.

Thus, if you name a beneficiary other than a spouse, and the estate tax and beneficiary are in the highest marginal income tax bracket, the IRS would tax the $1 million IRA first. An estate tax of 46% leaves a balance of $540,000. This amount can then be subject to a 35% income tax rate if the beneficiary proceeds to withdraw the entire amount all at once. In the end, the beneficiary would receive $351,000. (This assumes that all taxes are paid from the IRA asset and no generation-skipping tax applies.) "This is a bad tax result for the beneficiary," says Parker. In this instance, it may be more tax-efficient to leave the qualified plan to a charity, which would receive the entire $1 million tax-free. The transaction could then result in a $1 million charitable deduction for the estate.

"It is also possible to lose tax benefits by overusing beneficiary designations," says Parker. For example, consider an estate worth $5 million. If $4.5 million of the assets are transferred to heirs as beneficiaries of annuities, IRAs, life insurance and qualified and non-qualified investment plans, you may not be left with enough funds in the estate to use the $2 million estate tax exemption.

Deciding Whom to Name
Many estate assets typically pass to a surviving spouse. Upon his or her death, the estate assets usually pass to any surviving children. However, if you have children from a previous marriage or wish to support both your children and your grandchildren, it's advisable to consult your financial advisor about transferring assets out of your estate through beneficiary designations.

You may wish to consider the following scenarios when determining various beneficiaries:

  • Spouse. You may wish to designate your spouse as the beneficiary of several qualified plans and insurance policies and leave the estate assets to your children or vice versa. If your spouse is not a U.S. citizen, it's important to consult your financial advisor, because this scenario can trigger immediate taxation.

  • Minor child. If your child is a minor at the time of inheritance, all assets are placed into a custodial account until he or she reaches the age of majority. It's advisable to plan ahead by naming a custodian to manage the assets in a way that provides for your heir, and consider the protections provided by a trust. If you do not name a custodian, the executor of the estate must get a court-appointed custodian who may not be known by the family.

  • Unmarried partners. Without the benefit of spousal estate tax exemptions, you and your partner may best provide for each other as beneficiaries of an annuity. Typically, the beneficiary will pay income taxes, and may or may not be subject to estate taxes, depending upon the estate tax payment method you have selected as part of your overall estate plan.

  • Individual. A life insurance beneficiary generally is not subject to any income tax, but all proceeds are subject to estate taxes, unless it is owned in a properly structured irrevocable trust. In general, any transfers of wealth to an individual are subject to estate taxes, and depending on the financial vehicle, some level of income tax. Therefore, it's advisable to choose the most tax-efficient assets with this designation.

  • Charity. A charity typically does not pay estate or income taxes, so you may want to consider passing taxable assets to a preferred charity and tax-free assets to your family.

  • Estate. Because estates are subject to probate, an estate is rarely the first choice as a beneficiary. However, estates are commonly listed as contingent beneficiaries to ensure that your overall distribution plan is followed. Where an IRA or annuity is the asset, this may cause accelerated income taxes. In some cases?particularly where life insurance is the asset'the estate may be listed as the primary beneficiary to ensure that you use the $2 million tax exemption.


In order to maximize inheritance and tax benefits, it's advisable to make a careful audit of every asset you own and to review your primary and contingent beneficiary designations, advises Parker.

You may wish to discuss your designations with your financial planner as part of your annual estate plan review. Together, you can also consider how changes in your business, net worth, life circumstances and applicable tax laws may affect your estate plan and beneficiary designations.

Talk to Your Planner About:
  • The advantages and disadvantages of naming a trust as a beneficiary.
  • Moving assets into beneficiary designation accounts for the purpose of simplifying your estate planning.
  • Organizing a family meeting for the purpose of educating your heirs about your estate plan and intentions.


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