Beneficiary Designations: Why are they important? How do they fit into an estate plan? How can proper elections help your beneficiaries?
When you think of an estate plan, a Will or a Trust may come to mind. Both are good answers and certainly have their role – over the next few weeks I will dive deeper into what actually makes up an efficient estate plan.
However, for today I want to bring up what I believe to be one of the most underappreciated aspects of estate planning - creating and maintaining beneficiary designations on retirement and investment accounts. These elections are a crucial box to check in this important process.
Moreover, it is crucial to remember that beneficiary designations on your retirement accounts, bank accounts, and investment accounts typically SUPERSEDE your wishes laid out in your Will pertaining to the disbursement of these accounts.
Said differently, if you mistakenly list your ex-spouse as beneficiary, instead of your current spouse or children, and you pass away, your ex-spouse will receive these assets. There was actually an article in the Wall Street Journal recently that recounted a gentleman who listed his previous girlfriend as the beneficiary of his retirement account (they broke up in 1989) – he never changed the designation, and now his family is attempting to obtain the funds. There was $1 million in his account.
So, not only is it vital to ensure these elections are correct for the purpose of confirming your desired beneficiary will receive the assets, but also to (hopefully) avoid any potential hiccups in the disbursement of your estate. Again, a family member passing away is tough enough, best not to inadvertently complicate the situation with listing incorrect beneficiaries. In addition, listing beneficiaries allows the retirement accounts to avoid the probate process.
While the above refers to retirement accounts, it is also imperative to set up Transfer on Death (TOD) & Payable on Death (POD) Registrations for your investment accounts (non-retirement) and bank accounts. For bank accounts, this simple election serves to avoid the probate process by having the account directly pass to a designated individual(s).
However, the role the TOD plays for investment accounts is a bit more exciting. As a quick overview, investment accounts are non-retirement accounts that can hold stocks, bonds, mutual funds, exchange-traded funds (ETF’s), etc. – there is no limit on the contributions, and the gains realized are taxed at long term capital gains rates vs. ordinary income rates. Typically, long term capital gains tax rates are lower than income tax rates. If a capital loss is realized, then $3,000 of a loss can be written off against other income, and the remainder can be carried forward for future years.
Why does this matter in estate planning?
Well, let’s say a husband and wife own an investment account jointly and have rights of survivorship (JTWROS), meaning if one spouse passes away, the surviving spouse still retains ownership of the account. Let’s also assume the spouses set up a TOD registration on the account and list their son and daughter. So, upon the second spouses passing the son and daughter will receive equal shares of the account balance (50% each).
Again, you may be asking why is this important?
Well, let’s say Mom and Dad bought XYZ stock in the early days – for this example the cost basis (what was paid for the stock) is $10,000. They never invested further. Fast forward to today, the stock position is worth $200,00 – if Mom and Dad sell the stock they will pay long term capital gains taxes on the gain proceeds (15% for this example).
Mom and Dad pass away, the $200,000 stock position is now passed to the kids via the TOD registration. Under current tax laws, when the kids inherit their shares, ($100,000 each in this example) they actually receive a step-up in cost basis on the account position as of the account owner’s date of death. So instead of the cost basis on the account being $10,000, the cost basis is $200,000, and any gains realized are treated as long term capital gains.
So, the kids could go sell the $200,000 stock position after their parents pass away and pay $0 in capital gains taxes. Again $0. Not a bad deal – and the asset pass outside of probate!
Compare this to your children inheriting an IRA and being required to withdraw the entire balance and pay income taxes at their respective rates along the way – yikes!
In conclusion, creating and maintaining beneficiary designations is crucial in executing an estate plan that accomplishes your wishes, while also connecting the dots to other areas in your situation.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give tax or legal advice.