Proper Beneficiary Designations for Life Insurance

Many people own life insurance policies, either through their employment or as supplements to their employer-funded policies, or have individual retirement plans (IRAs) or employee benefit plans (usually 401(k) plans), but unfortunately, not much thought is given to the beneficiary designations for those policies or retirement plans. The typical designation will go something like this:

Primary Beneficiary: My surviving spouse

Secondary Beneficiary: My children

The problem with simple designations such as the above is that if you have a substantial estate or if you have minor children, you can be creating complicated situations for them in the future. For example, let’s say husband and wife are killed in a car accident. They each have insurance policies naming the other spouse as the primary beneficiary. They have two young children, who are 4 and 2 years old, listed as the secondary beneficiaries. The insurance company will not pay out the proceeds to the minor children because they do not have the legal capacity to accept the money. Because of the way the designation is made, the company’s only alternative is to pay the funds to a guardian of the estate for the minor children. A guardianship is a costly and time-consuming process that severely constricts the use and investment of the funds and requires that all a minor child’s share of the proceeds must be given to that child when they turn 18, when they are typically still financially irresponsible.

In addition, if you have a large enough estate, and you have prepared trusts under your Will to protect your exemption against estate tax (known as a “bypass” trust or “credit shelter” trust) or to provide trusts for your children for their future protection, and you planned on funding these trusts with the proceeds from the life insurance, you should be aware that for the tax and other planning contemplated by your Wills to work effectively, much of your property, other than qualified plans and individual retirement accounts (designations for these plans will be discussed in a future post), should pass under your Wills at your deaths. To the extent that you use “probate avoidance” methods of transferring your property at your deaths, some of your property may pass outside the provisions of your Wills (such property is referred to as non-probate property), and you could be circumventing the tax and other planning accomplished under your Wills. Some common types of non-probate properties are those that pass by beneficiary designation (insurance, annuities, individual retirement accounts, etc.) payable on death accounts (also known as “POD” accounts), joint tenancy with rights of survivorship accounts (also known as “JTWROS” accounts), revocable trusts and community property survivorship agreements. Accounts with payable on death beneficiaries or accounts which are held as joint tenancy with rights of survivorship can be convenient ways to dispose of small bank balances if properly handled, but if large amounts are involved, your estate plan could be seriously disrupted. Unless you have non-tax reasons for establishing survivorship accounts, survivorship agreements or payable on death accounts, as a general rule, you should avoid doing so, and you should change any such accounts that you may have previously established to joint accounts held as tenants in common (sometimes referred to as accounts with “No Survivorship”). This will help to ensure that such property does pass under your Will and to the beneficiaries named in your Will or into trusts created under the Will.

The importance of making sure that the death beneficiary designation on your life insurance and similar products like annuities is properly coordinated with your estate plan cannot be overemphasized. One way for you to designate the beneficiary on life insurance policies and annuities is as follows:

Primary Beneficiary: 100% Insured’s spouse

First Contingent Beneficiary: 100% Testamentary Trustee designated in the Insured’s last will and testament

By having it paid to the surviving spouse, the spouse has the right to either accept the assets outright, or if there is a trust created under the Will to protect against the possibility of estate taxes, the spouse can disclaim any or all of the proceeds, and let the proceeds pass to the bypass trust, of which the spouse is usually the beneficiary. The benefit is that while the spouse still can benefit from the policy proceeds, the proceeds will not be counted as part of his or her estate for estate tax purposes when the surviving spouse dies.

If the husband and wife die simultaneously, then the proceeds would automatically be paid to the contingent beneficiary—the Trustee for any trusts created under the Will for descendants of the husband and wife.

If all the children are adults, you can name them as contingent beneficiaries (or if you are unmarried, as the primary beneficiaries). But what if a child predeceases you? Do you want his share to pass to his children, or to your surviving children only? If you want it to go to your surviving children only, then the following designation (or something similar) should be used:

“In equal shares to my children who survive me”

If you want children of any deceased child to receive that child’s share, then you could use the following designation instead:

“To my descendants then living per stirpes”

Per stirpes is a term that essentially means that a deceased child’s share will pass in equal shares to his children. For example, let’s say you have three children. Each child, if they survived you, would receive a 1/3^rd share of the proceeds. However, if one child predeceased you leaving two children, then those two children would get ½ of the deceased child’s 1/3^rd share (or 1/6^th each). The two surviving children would still receive their 1/3^rd share.

The danger, of course, in using the above designations is that you might wind up with some minor beneficiaries and have the guardianship issue arise again. In such a situation, where you have trusts created under your Will for your descendants, the better choice may be to name your estate as the contingent beneficiary. In that scenario, the minor descendants’ share will be held in trust without the necessity of a guardianship.

The beneficiary designations listed above are by no means exclusive. You may have a list of persons you want to name as beneficiaries of your life insurance other than just your children. Further, you should be aware that naming your estate (as opposed to the Trustee under your Will) as the beneficiary of your life insurance can expose those assets to the creditors of your estate, if any creditors exist upon your death. For most people, this is not a concern, but because the above designations may not always be appropriate in every situation, before executing any new beneficiary designations you should check with your attorney or financial planner about the best way to style the designations. Spend some extra time making sure that the designations you use don’t conflict with the estate plan that you have in mind. You may create problems that you can easily avoid.

Duties of an Executor, Part Two

In my previous post, I covered the basic duties of an independent executor in Texas. The role of an executor is an important one, and requires attention to detail and an ability to deal with complex situations with the assistance of competent legal counsel or a certified public accountant. Not only are there issues involving the collection and distribution of assets or the payment of debts and expenses of the decedent, there may be tax considerations as well. Here are some issues concerning taxes that the executor may have to deal with during the administration process:

What about income tax considerations?
Most estates contain income-producing assets, which may require the independent executor to file income tax returns for the estate. These returns are normally prepared by the estate's accountant after consultation with the attorney. In addition, a final income tax return for the decedent must be filed for the year in which he or she died. If the decedent was married, a joint return may be filed including all of the decedent's income up until the date of death. The independent executor should also be alert for the possibility of an income tax refund due the decedent and should apply for it if one is due. Note that some estates are administered fairly quickly and the income is picked up and reported by the recipient, especially if the recipient is the surviving spouse. However, where there are several beneficiaries, and the estate administration takes several months (or longer), an estate income tax return (known as a Form 1041) will almost always be necessary.

An estate is not required to use a calendar fiscal year but instead may select another fiscal year. Substantial income tax savings and deferrals can usually be accomplished by a careful selection of the estate's fiscal year, so the estate's attorney and accountant should be called upon to make recommendations in this respect. This should be selected (or at least considered) early in the estate administration so that a short fiscal year can be selected if desirable.

The provisions of the 1986 Tax Act now require estates to make estimated income tax payments, although not until after the close of the estate's second taxable year. At the appropriate time, the independent executor will need to work with the estate's accountant in determining the correct estimated income for payment for the estate.

If the decedent owned any interest in any partnership, there are certain tax elections with respect to the basis of the property that should be considered. In some cases, additional tax benefits can be obtained if the partnership agrees to elect to alter the basis of the assets in the partnership with respect to the decedent's share.

Certain administrative expenses, such as executor's fees, attorney's fees, accountant's fees, appraiser's fees, court costs, expenses of preserving and distributing the estate, and expenses of selling property are deductible either on the estate tax return or on the income tax return of the estate. The decision as to how to derive the greatest benefits from these deductions will be determined by the independent executor, the estate's attorney, and the estate's accountant.

What about an estate tax return?
A federal estate tax return is due in many of the larger estates. If a federal return is required to be filed, a state inheritance return must also be filed. The estate tax return and the payment of any tax due is the duty of the independent executor. Normally, of course, the return is prepared by the estate's attorney working with the independent executor and the estate's accountant. Generally, it will be the independent executor's duty to supply the information needed to prepare the return.

The estate tax return is due within nine months from the date of death, unless an extension is obtained. An extension to file the return is generally available, although an extension to pay the estate taxes is rarely available. Thus, all estate taxes must generally be paid nine months from the date of death. There are some circumstances-e.g., where the estate owns a sufficient interest in a farm or family business or where the payment of the tax by the due date constitutes a hardship to the estate-in which the time for the payment of estate taxes may be extended. Relatively few estates will qualify for this, however. The independent executor should obtain approximate valuations of the assets as soon as possible, so a determination can be made as to whether assets should be sold to pay taxes and, if so, when they should be sold.

If the total value of all assets in the estate (before any deductions for debts and other expenses) is less than $1,500,000 (assuming the decedent died in 2004 or 2005--see this post for the exemptions in past or future years), an estate tax return is typically not required. It is normally necessary, however, except in estates for which it is clear the assets are well below that figure, to proceed as if preparing an estate tax return so it can be determined that no filing is in fact required. In addition, it is important to have the information available should the IRS ever claim that a return should have been filed. In addition, gathering such information will be helpful to the attorney in preparing the inventory for the estate for filing with the probate court.

Since the estate tax return requires considerable information and documentation (such as appraisals) for its filing, it is necessary to begin gathering the information for the return as soon as possible after the death of the decedent.

When and how are distributions made from the estate?
The timing and nature of the distributions from the estate to beneficiaries will depend upon the financial condition of the estate (including the amount of any debts owed by the estate and potential tax liability) and of the individual beneficiaries, as well as the tax consequences of the distribution. Before any distributions are made, the executor should consult with the estate's attorney or accountant or both.

The IRS has an unrecorded lien on real property owned by the estate if an estate tax return must be filed. Particularly when the executor considers selling real property, the executor should consult the estate's attorney regarding this issue. A procedure is available to the Independent executor should he or she need to obtain a release of the lien either for distribution or a sale of the property. The release will be issued if, in the judgment of the district director, it will not jeopardize the ability of the IRS to collect any outstanding balance or potential deficiency. Because obtaining the release may take a few weeks, it is generally advisable to begin this procedure early if the Independent executor anticipates selling property.

Because a final distribution normally will not be made until after the estate tax return has been audited or the estate has received a letter stating no audit will be made, it is likely the surviving spouse or other beneficiaries will desire some distributions prior to the final distribution. In addition, for tax purposes it is usually desirable to make interim distributions.

Any distribution will have a tax effect, so no distributions should be made until the consequences of those have been discussed with the estate's attorney and accountant and the tax effects have been taken into consideration.

Conclusion:

As can be seen, the tax issues surrounding an estate can be complicated. Make sure if you are acting as an executor that you get proper guidance before making any decision that could have an adverse tax consequence on the estate (and inevitably, on the beneficiaries of the estate).