Ask the Adviser: How should I use beneficiary designations in my estate plan? - Rodgers & Associates

Ask the Adviser: How should I use beneficiary designations in my estate plan?

When most people think about how their estate will be divided, they think it must be directed through their will. They often forget that benefi­ciary desig­na­tions added to an account can supersede what your will says for that account.

Struc­turing these desig­na­tions well can be a tremendous planning oppor­tunity, while ignoring them can lead to mistakes and damaged family relation­ships. For example, if you have a $1 million IRA and your will says to split all the money between Jimmy, Johnny, and Janey, and your desig­nated benefi­ciary says to split the IRA between Jimmy and Johnny, Janey is about to be in for a rude surprise.

There are two ways your assets will be directed after you die: by your will or by contract.

When we say, “by contract,” we mean through avenues like benefi­ciary desig­na­tions, account titling (i.e., a joint account with rights of survivorship), or assets held in a trust.

Any asset that isn’t trans­ferred by contract is directed by your will. For example, this would include assets held solely in your name that don’t have benefi­ciaries assigned to them. These assets are sometimes referred to as your probate estate. If many of your assets involve benefi­ciary desig­na­tions, joint accounts, or trusts, it’s very possible that a relatively small portion of your estate will be directed by your will.

Let’s look at an example of how benefi­ciary desig­na­tions can be used to your advantage. We’ll assume you have $3 million and want to split your assets evenly between your three children and one charity (with 25% going to each):

Individual Account$ 1,000,000
IRA$ 1,000,000
Roth IRA$ 500,000
House$ 500,000
Total$ 3,000,000

One approach is to write your will so that 25% goes to Jimmy, 25% to Johnny, 25% to Janey, and 25% to the charity, and to update your benefi­ciary desig­na­tions to match exactly what your will says. See below:

Individual Account$ 1,000,000$ 250,000$ 250,000$ 250,000$ 250,000
IRA$ 1,000,000$ 250,000$ 250,000$ 250,000$ 250,000
Roth IRA$ 500,000$ 125,000$ 125,000$ 125,000$ 125,000
House$ 500,000$ 125,000$ 125,000$ 125,000$ 125,000
$ 3,000,000$ 750,000$ 750,000$ 750,000$ 750,000

This would accom­plish your goal to give a quarter of the funds (or $750,000) to each benefi­ciary, but when consid­ering the tax treatment of each asset, it really wouldn’t be the best way to get there.

Instead, you may want to consider excluding the charity from your will and stating that your estate will be divided evenly between your three children. You would also exclude the charity from the Roth IRA. Finally, you would designate the IRA so the charity is a 75% benefi­ciary and your children evenly receive the rest (at 8.33% each). See below:

Individual Account$ 1,000,000$ 333,333$ 333,333$ 333,333$ 0
IRA$ 1,000,000$ 83,333$ 83,333$ 83,333$ 750,000
Roth IRA$ 500,000$ 166,667$ 166,667$ 166,667$ 0
House$ 500,000$ 166,667$ 166,667$ 166,667$ 0
$ 3,000,000$ 750,000$ 750,000$ 750,000$ 750,000

Here’s why that’s worth consid­ering: The money in the IRA is pre-tax, meaning you got a deduction for it when you put money into the account, but when you (or your heirs) withdraw the money, it will be taxable. The reason you’d want to give a dispro­por­tionate share of the IRA to the charity is because charities don’t have to pay federal income tax, whereas your children do.

You’d want to exclude the charity from your Roth IRA because that account is tax free, and a tax-free account is much more valuable to an individual than to a charity. For a charity, all accounts are essen­tially tax free, but for an individual, a tax-free account is special and should be taken full advantage of. After all, you likely chose to pay additional taxes on that money so it would grow tax free over time. It wouldn’t make sense to give that money to an organi­zation that wouldn’t have to pay taxes on it anyway.

The will would only cover the house and the individual account. Those are great assets to inherit because if they’re more valuable today than when you bought them, the kids’ cost basis for capital gains purposes would be whatever they were worth when you died. Therefore, if they sold the assets for what they were worth at the time of your death, they’d be able to sell them without any capital gains tax.

If we assume each of your kids is in the 24% tax bracket when they withdraw money from their inherited IRAs, struc­turing things this way would result in approx­i­mately $120,000 of tax savings across your estate. Instead of receiving $250,000 in IRA money, they’d only receive $83,333 in IRA money, a difference per child of $40,000 per child ($166,667 x 24% federal tax rate = $40,000). With these sugges­tions, they’d end up with $730,000 after taxes versus $690,000 by just dividing things evenly.

So why doesn’t everybody do this? Well, it requires some monitoring over time. The value of your IRA may end up being a lot higher or lower than it was when you first set up the forms. These values change due to many years of investment returns, or because of larger IRA withdrawals as you age. This could result in the charity or kids getting a much different percentage of your estate than when you first drew up the plan.

Benefi­ciary desig­na­tions are easy to change, and you can make updates directly with your financial insti­tution without needing to pay a lawyer to draft documents. That said, we strongly suggest talking to your attorney to ensure any changes will still meet your estate planning goals. We also suggest meeting with your financial adviser every year to review the projected values your heirs will receive if you unexpectedly pass. If the values are different from what you think they should be, you may need to adjust the percentages through your benefi­ciary desig­na­tions or other estate documents.