Best practices for beneficiary designations

Morningstar, Inc., in collaboration with E*TRADE Securities


In contrast to the careful effort we often put into drafting trusts and wills, many of us don't give very much thought to the beneficiary designations on our investment accounts. We may have made our beneficiary choices years ago without considering tax or other ramifications, and we might never have updated them to match the changes in our lives—marriages and divorces, births and deaths, relationships improved or turned sour. What many people don't realize is that those designations are binding and, in most cases, will override whatever is laid out in a will or trust.

If you never gave your beneficiary designations much thought or you haven’t kept them up to date, it's time to revisit them. Take a look at this list of top dos and don’ts for beneficiary designations and read on for the reasons behind them.

Do: Start with how you feel

Who do you care about most and want to be financially secure? There may be financial issues to consider before making certain individuals your beneficiaries—such as minor children or special needs loved ones—but often the right answer is your nearest and dearest.

Do: Recognize the benefits accorded to spousal beneficiaries

Most of us naturally want our spouses to inherit any assets we hold in our own names. But if you're considering another plan—maybe your spouse has a lot of his or her own assets but you're worried about your sister's financial well-being—bear in mind that spouses who inherit certain assets get special treatment in the tax code.

When it comes to inherited IRAs and 401(k)s, for example, only spouses can roll over those assets into their own retirement accounts. Likewise, spouses who inherit health savings accounts can roll over the HSA into an HSA of their own.

Rolling those assets into their own accounts will enable the surviving spouse to take greater advantage of the tax benefits associated with the assets. So, it often makes sense to name a spouse as the beneficiary for that kind of account. Meanwhile, you could consider earmarking other assets, where spouses don't receive a special tax benefit when inheriting, for other loved ones—the assets in a taxable brokerage account, for example.

Do: Make sure your beneficiary designations sync up with other parts of your estate plan

If you've taken additional steps on your estate plan beyond your beneficiary designations—for example, you've drafted wills and trusts—make sure your beneficiary designations sync up with the rest of your plan. It's common for people to make beneficiary designations first and create other estate-planning documents later, when their families have grown. The documents may contradict each other, but the beneficiary designations will generally trump what's in the will or trust, regardless of which paperwork was completed first.

An estate-planning attorney will typically cover beneficiary designations when setting up your plan and will give you instructions about how to update your beneficiary designations to match the rest of your plan.

Do: Name contingent and/or partial beneficiaries

In addition to naming a primary beneficiary for a given asset, most beneficiary designation forms let you name a contingent or backup beneficiary. For example, you could make your spouse your primary beneficiary, and your brother the secondary beneficiary in case something happened to you and your spouse at the same time.

Similarly, you can also divide assets among multiple beneficiaries. For example, you could designate both your brother and sister as 50% primary beneficiaries of your 401(k) plan and name your favorite nephew and niece as 50% contingent beneficiaries each.

Don't let yourself be limited by the number of lines on the form. Call your provider if you can't make your designations fit and make sure to ask for written confirmation of your choices.

Do: Consider charities or other nonprofits

Remember that you can also designate charities and nonprofit educational institutions as beneficiaries. If there are tax-deferred gains in the account—as in a 401(k) or IRA, for example—the charity or other nonprofit can avoid taxes on the whole amount. Again, don't be limited by the number of lines on a form. You could give each of your two adult children 45% of your IRA but leave the other 10% to a charity that speaks to your heart.

Do: Check your beneficiaries when you review your portfolio

From divorces and remarriages to births and deaths, life situations change, and so should your beneficiary designations. Be sure to revisit yours periodically. Many advisers recommend reviewing your portfolio at least once a year, and that’s a perfect time to also review your beneficiaries.

Beneficiary designations can also fall through the cracks when you change financial providers—for example, if you roll over your IRA assets from one firm to another. This can also happen with employer-provided plans: If your employer has switched 401(k) providers, check to make sure your beneficiary designations have carried over along with your contribution rate and other choices you've made.

Don't: Leave assets to minor children without understanding what that means

Just as many married people want their spouses to inherit their assets, many parents naturally want their children to do so. Bear in mind, however, that minor children can't inherit assets outright.

If a child inherits a small financial asset—what counts as "small" varies by state—a parent or other guardian may be able to transfer the money into a UGMA/UTMA account or 529 plan, where it can grow until the child reaches the age of majority. That's not ideal for assets that had previously been in an IRA or 401(k), however, because UTMA/UGMA and 529 accounts have fewer lifetime tax benefits and may benefit less from compounding than inherited IRAs do.

If you'd like to make a child the beneficiary of an account like an IRA or 401(k), it’s a better idea to make the child the beneficiary, then specify a custodian to manage the child's financial affairs until they reach a specific age. (The custodian can be the same person as the child's guardian, or it can be someone else.) Alternatively, you could make a trust the beneficiary of your IRA; your trust documents, in turn, can spell out how that money is to be managed and distributed to your heirs. That might sound ideal but setting up and managing trusts can be costly.

Don't: Leave assets to loved ones with special needs without considering the ramifications

If you have a special needs loved one in your life, bear in mind that there could be financial complications of transferring assets directly to them. You could affect your loved one’s eligibility for government-provided benefits. In addition, if they have an intellectual disability, they may not be able to manage the assets.

If you're in a position to transfer a large amount of assets to a loved one with special needs, consult with an attorney who specializes in estate planning first. The attorney may recommend that you set up a special needs trust.

Don't: Designate to someone who's not the end owner

Sometimes people will make a single person the designated beneficiary for an asset, even though they intend for that person to split the money among other heirs. This has major potential pitfalls. The beneficiary may not remember your original wishes correctly, and even if they do, they aren't legally required to follow them. In addition, if you leave a very large pot of money to one person, you might create estate tax headaches for them. Bottom line: be as specific as possible on beneficiary designations. For example, if you want each of your five siblings to inherit equal shares of your 401(k), make each of them a 20% beneficiary.

Don't: Assign beneficiaries to only tax-advantaged accounts

Beneficiary designations for IRAs and 401(k)s get the most attention, probably because they're worth the most money in many households. But don't neglect beneficiary designations for nonretirement assets like taxable brokerage accounts.

A transfer on death registration lets you transfer such accounts to someone else upon your death, allowing the assets to avoid probate; a similar registration type, called payable on death, is available for bank accounts. Check with your financial provider to set up such a registration.

If you'd like to leave taxable bank or brokerage accounts to multiple beneficiaries, it's smart to do so via your will rather than transfer/payable on death registration.

Don't: Make inadvertent beneficiary designations

In a related vein, older adults often add an adult child as a joint owner on their checking accounts to help oversee bill-paying. But there are potential drawbacks. The child is free to withdraw from the account as they see fit; the account could be vulnerable to the child's creditors; and that child would own the account free and clear when the parent dies, regardless of whether that's what the parent wanted.


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