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Don’t Overlook This Financial Planning Step

Investment

One of the more overlooked but important areas of financial planning are investment account beneficiary designations. Though a mundane topic, especially for busy individuals and families, understanding what your accounts currently say about who gets them is one of the more consequential paperwork planning decisions.

The Most Important Fact: Your beneficiary designation on a retirement account (and life insurance policy) overrules a will. For example, if a will leaves everything to a current spouse but an old 401(k) still shows an ex-spouse as beneficiary, the ex-spouse is entitled to receive that old 401(k) money. A lawyer and executor cannot redirect the old 401(k) proceeds, and the 401(k) custodian pays whoever is listed on the beneficiary form. Many update wills after remarriage or divorce but forget to update beneficiary forms. This is one of the more common estate blunders and can prove stressful and costly.

Other common beneficiary missteps:

  • Old 401(k) with outdated designations. These often reflect who you were when hired years ago, usually before marriage, children, or a parent's death.
  • No Health Savings Account (HSA) beneficiary on file. The account defaults to the estate which is a bad outcome for an HSA (more on this later).
  • No contingent beneficiary. If the primary beneficiary predeceases you, the account can transfer to your estate. This typically means probate and possibly adverse tax treatment.

401(k) and IRA Beneficiaries. There’s a difference 

The 401(k) and IRA have different beneficiary rules. Also, neither account type works like a will. For 401(k)s, 403(b)s, and other ERISA plans, federal law makes your spouse the automatic primary beneficiary. Notarized spousal consent is required if you want to name someone else. Without it, the designation is unenforceable and the spouse receives the account anyway, which affects blended families. IRAs are different. State law governs them and you can name anyone as a primary beneficiary, though community property states can add their own twists to them.

Beware The HSA Tax Bomb

If a spouse inherits an HSA tax-free, and it stays an HSA with its tax-free advantages intact. This is a unique and generous feature. For anyone else, the account stops being an HSA at your death, and the full value becomes ordinary income to the beneficiary in a single year, with no 10-year window. So, a $100,000 HSA left to an adult child could create a $30,000 federal tax bill. Beneficiaries can offset some of this by paying the decedent's unpaid medical expenses within one year, but most miss the deadline given the short timeline and paperwork headache.

Per Stirpes vs. Per Capita

Perplexing terms indeed. These are Latin terms used in wills, trusts, and beneficiary designations to control how an estate is divided if a beneficiary dies before you. Per stirpes and per capita can be easy to miss and hard to understand on beneficiary forms. Many forms include a small box for this election, and many people skip it due to confusion. 

The difference between the two really matters. For example, say you name three children equally and one dies before you, leaving two grandchildren. With per stirpes, those grandchildren each receive one-sixth. With per capita, the deceased child's share goes to your two surviving children, and the grandchildren receive nothing. Often, families with multiple children want per stirpes, however forms can default to per capita or just left blank.

“The only things certain in life are death, taxes, and people procrastinating their estate planning.”

Most beneficiary assignments are correct, but an ongoing, vigilant plan to check is important.  Many plan to update beneficiaries when life circumstances change like a marriage, death, birth etc. The challenge with this can be the lack of time and attention during these major events to focus on beneficiary changes.

Doing well with money often has less to do with smarts than with proper behavior. Financial success tends to reward the unglamorous habits, and few are more worthwhile than making sure your accounts will pass to exactly who you intend.