Most people think that a will is the only document you need for an estate plan—not true! A will directs how your “probate assets” are distributed. Probate assets are assets that are owned solely by you (i.e., no joint owners) and have no beneficiaries named on the account. A retirement plan, such as a 401(k) or IRA, is not a probate asset. Your retirement plan is to be distributed in accordance with the beneficiary designation forms that you complete. It is possible for your will to direct your assets to be distributed to one person, and your beneficiary designation form to direct your retirement plan assets to a different person. Sometimes, this is intentional, and if so, generally done for purposes of minimizing tax consequences. However, many other times, this is a mistake that is overlooked and has unintended consequences.
Why is it important to complete the beneficiary designation form?
Control Who Inherits
Without a properly completed beneficiary designation form, the contractual provisions of your retirement plan will control who inherits your retirement assets. In most cases, the default beneficiary is your estate. However, other retirement plans may state that other persons directly inherit your retirement plan.
You have worked hard during your lifetime to save this money. You should be the one to decide who inherits the funds.
Protect the Funds From Your Creditors
If you intend for the same people to inherit both your probate assets and your retirement assets, it might seem easier simply to name your estate as the beneficiary of your retirement assets and allow all of the assets to be distributed in the same manner. Be warned—by doing so, you are putting your retirement assets at risk of your creditors.
Assume that you die with $100,000 of probate assets (bank accounts, equity in a house, vehicle) and $200,000 of retirement assets. Also assume that, upon your death, you have creditors (credit card companies, a nursing home and medical providers, or even a plaintiff in a lawsuit who obtained a judgment against you). Generally, those creditors can be paid only from your estate. So, if you owe more than $100,000, and if you properly completed your beneficiary designation forms for your retirement assets, those creditors can take only the $100,000 from your estate while your beneficiaries receive all $200,000 of your retirement assets. However, if your retirement assets are distributed to your estate, either because you named your estate on your beneficiary designation form, or your estate is considered the default beneficiary, then your creditors can also be paid from the retirement assets that become part of your estate, and your beneficiaries will not benefit from your hard work.
Protect the Funds From Your Beneficiary’s Creditors
Many people are concerned about protecting beneficiaries from themselves and their creditors. For this reason, many people set up a trust to manage the funds for the benefit of the intended beneficiaries. For example, you could name a local trust company to manage the funds for the benefit of your children until each child reaches the age of 35.
A common mistake with this plan is to name the children instead of the trust on the beneficiary designation forms for the retirement plans. What is the result? Assume the previous situation where you have $100,000 of probate assets and $200,000 of retirement assets. If you establish a trust for your children under the age of 35, but name the children (rather than the trust) as beneficiary, you end up having $100,000 held in trust until they turn 35, and the other $200,000 going to them directly as early as age 18.
Having a will in place is a great start for an estate plan, but the planning should not stop there. Reach out to your lawyer to discuss the next steps, and make sure all of your beneficiary designation forms are completed properly.