Who to Name as a Beneficiary

In almost every first appointment that I have with new clients I find myself drawing a line down the middle of a piece of paper. On one side, I write "Probate" on the other side, I write "Not Probate." From my perspective as an estate planner, my clients' assets divide into these two main categories. The assets on the right side (Probate) are the ones that we will use to fund their living trust: houses, bank accounts, investment accounts, partnership interests, and the like. The assets on the left side (Not Probate) are all of the retirement accounts that they have, as well as life insurance proceeds, and any payable on death or transfer on death accounts that they may own. I tell them that the assets in the "Not Probate" category are over there because of the kind of assets they are--all of them will pass by beneficiary designation at death, not by Will or by trust.

Categorizing assets in this way is often new to my clients. To them, it is all just one thing--their money. But the distinction is important for estate planning for two main reasons:

  1. All of the "Not Probate" assets will pass to the designated beneficiaries regardless of what a Will or a trust says to do, so it's critical to review and update these beneficiary designations periodically. If a person dies and leaves their retirement account to two of their four children, this is bound to cause unhappiness.
  2. Retirement assets, unlike any other estate assets, pass to the beneficiaries subject to income tax upon withdrawal and come with complicated rules about how much and when the assets can be withdrawn by those beneficiaries. If, for example, a person funds their trust with $3 million worth of assets, but has amassed $9 million in retirement, their estate plan needs to take into account how these retirement accounts are to be distributed and taxed. In an estate that's so lopsided, the Will or the trust is really secondary to what the family's beneficiary designations say. And in an area like Silicon Valley, where some of my clients have worked their entire lives at Stanford University, such a lopsided estate is fairly common.

I always tell my clients to name their spouses as their primary beneficiaries. Not only do most people want their spouses to make use of retirement assets in this way, but there's a big tax advantage for surviving spouses. First, they can roll these assets into their own IRAs or keep them as an inherited IRA; Second, they can (in most cases) defer withdrawing inherited IRA assets until they are 70 1/2, which can be a large advantage to a younger spouse, since these assets can continue to grow free of tax until withdrawal.

When someone other than the surviving spouse is named the beneficiary, that person is going to have to start withdrawing the assets in the year following the person's death. From the government's perspective, the decedent got to save money during their working years, and defer the tax due until they turned 70 1/2, when the government required them to begin annual withdrawals that were then taxed (but at a lower rate than they would have paid during their prime earning years). But, now that the person has died, the government wants the money to start coming out of the account (and be subject to income tax) as soon as possible.

The required minimum distribution (RMD) varies depending on:

  • The life expectancy of the beneficiary, or the taxpayer’s life expectancy, depending on the circumstances (mostly how old the decedent was when he or she died)
  • Whether the account requires distribution of a lump sum or over a five-year period on death, or if it can be a “stretch” distribution based on the beneficiary’s life expectancy

401(k) plans and IRA plans may have different sets of rules about withdrawals and required distributions. And Roth IRA's (and their cousins) have different tax implications for beneficiaries as well. Clients with minor children will want to name their trusts, as opposed to minor children directly, as secondary beneficiaries to make sure that the successor Trustee can manage these assets for the children. Naming trusts as beneficiaries, however, requires special provisions to protect the children's ability to withdraw these retirement assets as slowly as possible.

If you or your friends have questions about how best to integrate retirement assets into an overall estate plan, feel free to get in touch and share this article with them.