Be Careful Who You Name as Your Beneficiary


So, you’re in the process of developing your estate plan. It is now the fun stage of determining who you should leave your assets to. There are many pitfalls that can emerge if certain assets are left to the wrong beneficiary.

Your family is unique

Let’s begin with the example of a married couple (John and Mary), age 65 years old with 3 children. Not all children are created equal. Often times, it is the desire of the husband and wife to treat their children equally. However, an in depth look at the children reveals potential problems.

There are a number of considerations that may alter the plans of this husband and wife. They include but are not limited to taxes, grandchildren, credit issues, college education, career success, divorce and spendthrift children.

Back to John and Mary who have three children. First, Lenny, 33 years old with a wife and 2 children (ages 8 and 6). Next, Samantha, age 43, divorced with 2 children. She has a 19 year-old (in college and receiving $25,000 a year in tuition grants and other financial aid). She also has a high school senior headed for college next year. Finally, there is William, age 39, who has never been married and has no kids.

Lenny and his wife earn $90,000 a year and (after deductions) are in a 12% Federal income tax bracket. Samantha earns $45,000 a year, and after deductions, is in a 12% bracket. William is earning $165,000 of taxable income, after deductions, placing him in a 32% tax bracket.

John and Mary have a $400,000 home, a $400,000 stock brokerage account and $500,000 in IRAs totaling $1,300,000 in assets. They are religious people who want to leave $100,000 to their church. The balance will go to their family – in equal amounts. John and Mary have “Reciprocal Wills” leaving everything to one another. They want $100,000 given to the church and the balance of assets distributed equally among their children. The IRAs name the 3 kids as co-equal beneficiaries.

How will the estate be divided?

If John and Mary were killed in a common accident today, what would happen? First, the IRAs would be split 3 ways, giving each child $166,670 in taxable income. (The distributions could be delayed up to 10 years from date of death and would be taxable to the recipients.) Assuming a 10-year distribution and today’s tax rates, Lenny would receive $146,666 of the IRA money after taxes. Samantha’s similar distribution could cost her $20,000 in financial aid for as long as her children are in college. With 2 kids in college, her net after-tax inheritance of $146,666 could reduce college financial aid by $100,000 or more! As for William, in a 32% bracket, he would wind up with only $113,333 after taxes.

Next, the sale of John and Mary’s home would provide each child 1/3 of the proceeds, or $133,333 net (tax-free). It is tax-free because the home got a step-up-in-basis to the date of death of the parents.

Finally, the $400,000 brokerage account also receives a “step-up-in-basis.” The church would receive $100,000 as John and Mary intended. The remaining amount of $300,000 split 3 ways.

Hence, under this scenario we see a large difference for the children in the value of their inheritances. Lenny receives the most with a net total of $380,000. Brother William receives $346,000. And Samantha – after the loss of financial aid – could wind up with as little as $280,000. This is not the result John and Mary envisioned!

Adding value for beneficiaries

How could you avoid such a huge discrepancy and add value for your children? There are many different options that can help accomplish these common goals. Let’s take a look at one example.

First of all, John and Mary decide to set up a Revocable Trust. They place their home and their brokerage account into their new trust. This type of trust allows the couple to retain control and access to their brokerage account and home value.

Next, they name their church as beneficiary of $100,000 of the IRA, with the balance going to the trust. The trust is designed to hold the IRA assets for the benefit of their 3 children after their deaths.

Furthermore, John and Mary require trust assets at their death to be split into separate trusts to benefit each child. No distributions of either principal or interest may take place for the 5 years subsequent to their deaths. After 5 years, each beneficiary can take control of their trusts and have them disbursed as they see fit. They will also be able to choose their own investment advisor and invest their proceeds as they see fit.

Protecting assets from creditors

As a result, the inheritance for the children is much more equal with an extra $118,000 of value added! First, the $100,000 of IRA money given to the church is done so 100% tax-free. That saves $4,000 of taxes for Lenny and Samantha, and over $10,600 in taxes for William. Next, Samantha does not lose her financial aid for her children. This can be a huge savings for her – as much as $100,000 or more in the example above. Finally, for 5 years, while in the separate trusts for the children, the assets are protected from all creditors.

In summary, there are many other different beneficiary-naming tactics that can be applied. The key is, in structuring your affairs, to consult with a competent Financial Advisor/Estate Planner who can help you make sure that what you want to happen will happen in the event of your death or a permanent disability.

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