What Are Beneficiary Designations or Transfer on Death Designations?
Many people use beneficiary designations as an alternative to doing proper estate planning. Why not? It’s quick and easy! It avoids probate! It allows you to rest easy that you have provided for your spouse, children, or other loved ones, to receive their inheritance immediately after your death, without probate or other delays!
Unfortunately, as happens in life, Mr. Murphy and his law of unintended consequences often rears his ugly head to cause things to happen differently than expected.
First, let’s examine what is a beneficiary designation, or payable on death designation. A beneficiary designation is a document that you sign, typically in association with life insurance policies, retirement plans including IRAs, and annuities. The beneficiary designation directs the institution involved how to distribute your life insurance or retirement funds upon your death. A related concept is a “payable on death” designation that you might provide to your bank or credit union to provide for the distribution of your bank accounts upon your death. Similarly, you can provide your brokerage firm or your mutual fund company, or even on individual stocks and bonds, a payable on death designation that directs where those funds will be distributed upon your death. There also are a few states that allow for a “beneficiary deed” that allows you to file a deed in the public records that will direct the distribution of your real property at your death to those that you have designated in the beneficiary deed.
What is the Problem With Using Beneficiary Designations?
What could be easier? The designated beneficiary simply provides the financial institution with a death certificate and the funds are immediately distributed out to the beneficiary, or transferred to the beneficiary’s account, and the transfer of the inheritance is complete. No courts, no lawyers, no creditors, no delays, no probate, no hassles! What possibly could go wrong? In fact, lots can go wrong, and does go wrong, often effectively destroying the inheritance you expected your loved one to reap the benefits.
Beneficiary designations and payable on death designations are contractual in nature. That means they happen automatically when the triggering event occurs – death in this case. Upon presentation of the death certificate, the bank, brokerage company, life insurance company, retirement plan company, or other party to the contract is legally obligated to distribute your assets exactly as you have set forth in the beneficiary designation. No exceptions are allowed.
So, what happens if your beneficiary died before you, or with you? You didn’t have time to change the beneficiary designation after the beneficiary’s death. Now, where do the funds go? Maybe to the beneficiary’s heirs? Maybe to the beneficiary’s probate estate, and subject to that estate’s creditors. Maybe to your estate – again, potentially subjected your assets to your creditors in your probate estate! The answer to that question is in the terms of the contract with the institution who provided you the agreement that provides for the beneficiary designation, or payable on death designation. Most often, that contract has a reference that incorporates the financial institution’s policies and procedures manuals, or in some other fine print. Unless you ask, you don’t know. Most people don’t ask.
Maybe your beneficiary didn’t die before you, but was rendered incapacitated because of a stroke, heart attack, accident, illness, etc. Now where do your funds go? An incapacitated person cannot manage assets. The financial institution in all probability will not distribute assets to an incapacitated person. The institution will require that a court supervised guardianship be established to accept the distribution of your funds. Now the probate judge is in charge. There is a guardian appointed to manage the assets of your incapacitated beneficiary. The guardian gets a fee paid out of the assets you left the incapacitated beneficiary. The guardian must hire an attorney to represent the guardian in the probate court. The attorney’s fees also come out of the assets you’ve left for your beneficiary. Anytime there is a need for funds for your beneficiary, the attorney, or the guardian, or both, must request that the court approve their request for funds to provide for your incapacitated beneficiary. What happened to probate avoidance?
Or, just maybe, your beneficiary is going through a divorce or a bankruptcy, or has creditor issues at the time of your death. Then what happens to the inheritance you left to your loved one through the beneficiary designation? If it’s a divorce, the divorcing spouse may be able to make the case that the funds you designated to your beneficiary constitute a marital asset and will be subject to equitable distribution in the divorce proceeding. With a bankruptcy, it is highly probable that the entire inheritance will be required to be paid to the bankruptcy trustee and will go to the beneficiary’s creditors in the bankruptcy proceeding. If there is a judgment against your beneficiary, or a tax lien, the judgment creditor or the tax authorities will immediately seize the inheritance from the beneficiary. Not exactly what you had in mind when you signed that beneficiary designation form, is it?
All of those potential circumstances are totally beyond your control or knowledge at the time you sign the beneficiary designation. In short, you have given up all control over what happens to your assets when you sign the beneficiary designation form directing that your assets be distributed to one or more individuals. Those are just the things that can go wrong that you have no control over. You also have lots of room to make mistakes when designating beneficiaries that can cause unexpected consequences.
The Ten Biggest Mistakes When Using Beneficiary Designations
There are many other mistakes that can be made when dealing with beneficiary designations and transfer on death accounts. The American Association of Independent Investors, in an article in its AAII Journal listed these Top Ten Mistakes made with Beneficiary Designations:
- Not Naming a Beneficiary
- Not Designating Contingent Beneficiaries
- Failing to Keep Beneficiary Designations Up-to-Date
- Naming Minors as Direct Beneficiaries
- Naming Special Needs Individuals as Direct Beneficiaries
- Naming Financially Irresponsible Beneficiaries
- Naming Direct Beneficiaries on All Assets Other than Real Estate
- Naming Multiple Beneficiaries on a Transfer on Death Real Estate Deed
- Naming a Child as a Co-Owner of a Deposit or Investment Account
- Naming One Child as the Sole Beneficiary of Insurance or an Investment Account
To review all of the problems that can be created from the above Top Ten Mistakes, you can read the entire AAII Journal article here.
What is the Solution?
For those who want to have control over the distribution of their assets so that the inheritance they leave actually goes to the beneficiaries they desire, with appropriate contingent instructions to ensure that if circumstances should be different than expected (Murphy visits to impose his Law), the most effective solution is the use of a revocable living trust. A properly drafted revocable living trust allows the trust maker (you) the ability to provide for all of the contingencies identified above.
With a revocable living trust you can provide that distributions for an incapacitated beneficiary be held in trust for the benefit of that beneficiary without the necessity of a court supervised guardianship. You can provide for discretion to allow your successor trustee to hold funds in trust pending the confusion of a divorce or bankruptcy. You can provide spendthrift clauses and discretionary distributions to ensure that a beneficiary with creditor problems gets the full use and benefit of the inheritance you left for them. You can provide in a revocable living trust for the “re-distribution” of your assets in the event one or more of your beneficiaries dies before you or with you. You can make provision in a revocable trust for minor children and special needs children to avoid guardianships and loss of public benefits in the case of special needs children or adults. You can provide safeguards for beneficiaries who may be irresponsible where financial matters are concerned. A revocable trust allows you to have one place where all of your assets are accumulated and allocated as you have provided without the need to rely on one child to “do the right thing” when distributing your assets to your beneficiaries.
In short, when you use a properly drafted revocable living trust you stay in control of your estate to ensure that the assets you have are distributed to the beneficiaries that you want, and that the distributions actually benefit those beneficiaries, and that the distributions are made when you want, and how you want, protecting your beneficiaries from creditors, divorcing spouses, and sometimes themselves, notwithstanding the appearance of Murphy’s and his law
Before you decide to rely exclusively on beneficiary designations and payable on death designations to transfer your assets, consult with an experienced estate planning attorney to learn about your options that can bring more certainty and control to your estate planning.