By Maurice R. Kassimir and Melvin L. Maisel

When individuals execute their wills, their goal is to ensure that their assets pass to their beneficiaries as they intend. Sometimes the testator wants to make an outright gift. Other times, the gift is made in trust. It is worth remembering that a will disposes only of the specific assets in an individual’s probate estate. Many assets do not pass under a will, including items disposed of pursuant to beneficiary designations, such as individual and group life insurance policies, IRAs, and all qualified retirement plans (QRP). Other assets passing outside the will include joint bank and brokerage accounts, jointly owned real estate, contractual rights under deferred compensation agreements, employment contracts, and ESOPs.

An individual may spend time creating a will to achieve testamentary objectives while maximizing estate tax savings opportunities. Unfortunately, many fail to ensure that estate plans properly address assets passing outside the will. Because prototype beneficiary designations frequently contain limited space or assumptions about intent, it is important to pay close attention to all beneficiary designations to ensure a comprehensive estate disposition.

A detailed review of assets will often reveal that the vast majority of assets will pass outside of the will. Typically, an individual will jointly own a principle residence or a second residence. There are often several life insurance policies with beneficiary designations, filled out long ago with the insurance application. An individual’s QRPs and IRAs will also pass outside the will pursuant to a beneficiary designation.

Many problems can arise with assets that pass outside a will pursuant to a beneficiary designation. When purchasing a life insurance policy, establishing an IRA, or participating in a QRP, little thought, if any, is given to properly completing the beneficiary designation. In many instances, it could be difficult to even locate copies of the beneficiary designations. Each asset, especially ones that have passed from prior custodians, should be properly traced so that testamentary objectives are actually fulfilled. The failure to do this could lead to a false sense of security.

A common error occurs when the testator has included in a will trusts for a minor, for a child over age 18, or for a disabled child, but forgotten to coordinate the beneficiary designations with the overall estate plan. The individual might designate the spouse as the primary beneficiary and the children as contingent beneficiaries. In such a case, the children will be entitled to inherit the property at age 18 rather than fulfill the terms of the trusts in the provisions of the will.

People make numerous mistakes in filling out their beneficiary designations. Failing to prepare a beneficiary designation that coordinates with the estate plan will not only involve Surrogate’s Court but could result in distributing too much money too soon. Incomplete beneficiary designations may also result in disinheriting children or grandchildren if the offspring of children predecease the owner.

Minor as Beneficiary

The most egregious errors fail to properly plan for minors. Under a will, trusts are generally created for minors. These trusts often delay mandatory distributions until the child is of a certain age. In today’s litigious environment, attorneys increasingly suggest lifetime trusts for children, which provide substantial creditor protection if the child is sued or divorces. Children that are designated as beneficiaries, however, will be entitled to inherit property at age 18 despite the terms of the will. The Surrogate’s Court would appoint a guardian to control and invest the assets in the interim. When the child comes of age, he may face a host of personal difficulties as a byproduct of sudden wealth. Failure to pay attention to beneficiary designations could inadvertently create problems no parent would intend.

Estate as Beneficiary

Another mistake can arise if the estate is designated as beneficiary. For example, consider a 401(k) participant that affirmatively designates the estate as beneficiary. Having the estate as beneficiary generally creates two problems. First, assets otherwise protected from the claims of creditors are no longer protected. Second, if the estate is the beneficiary of an IRA or QRP, there is an acceleration of income tax. The financial and tax benefits of deferring distributions from IRAs and QRPs by implementing a minimum distribution stretch-out are lost if the estate is the beneficiary.

Spouse as Beneficiary

A testator that does not want to leave property outright to a surviving spouse may draft a will that creates a qualified terminable interest property trust (QTIP). If the testator fails to designate the QTIP as the beneficiary of the required minimum distribution, however, the IRA or QRP will pass directly to the spouse. While a spouse is required to be beneficiary of a QRP under the Retirement Equity Act of 1984, this requirement can be waived with the consent of the spouse or by agreement through a post-nuptial agreement.

It is also critical to revise designations after a divorce to ensure they conform to the provisions of the will. In most cases, individuals want assets to pass to children, not stepchildren. Children from first marriages are often inadvertently disinherited because beneficiary designations are not properly filled out. This occurs when a second spouse, designated as the primary beneficiary, rolls over the deceased spouse’s account balance into a new IRA with her own children as beneficiaries.

Life Insurance in and out of a Qualified Retirement Plan

Life insurance proceeds may be the most substantial asset of the testator. Policy owners should ensure that the proceeds will be paid in a manner consistent with the will by properly drafting beneficiary designations. Designating a minor as beneficiary can create difficulties. Designating a second spouse may result in disinheriting children from a prior marriage.

To remove the insurance proceeds from the taxable estate, ownership of the policy is generally placed in an irrevocable life insurance trust (ILIT). It is critical that the trustees prepare a beneficiary designation that coordinates with the overall estate plan. Unfortunately, this part of the plan is often overlooked.

When insurance is owned in a QRP, the plan trustee should be designated as beneficiary. Once in receipt of the proceeds, the plan trustee should distribute the proceeds in accordance with the participant’s beneficiary designation. Without attending to these important details, disastrous results may occur, including the acceleration of income taxes, the subjecting of proceeds to creditor claims, and the passing of assets to unintended beneficiaries.

Group life insurance policy forms typically provide little space to properly designate the beneficiary. Newly hired employees do not always complete beneficiary designations. The same problems exist with split-dollar arrangements. Proper attention to beneficiary designations is necessary to fulfill testamentary objectives.

Because QRPs are subject to both estate and income tax at death when the spouse is not beneficiary, paying for life insurance on a pretax basis can significantly enhance the amount available for heirs. However, careful attention must be given to the necessary legal documentation. Unfortunately, QRP trustees are often not knowledgeable about how to treat life insurance proceeds. When permanent life insurance is owned by a QRP, the cash value is an asset of the participant’s account. Upon death, when the insurance proceeds are collected, the spouse has the option to transfer the cash value to a rollover IRA. The proceeds in excess of the cash value (the at-risk component) can be paid to the designated beneficiary income tax–free. Unfortunately, many trustees of QRPs are unaware of these rules. Instead, they distribute the entire insurance proceeds to the beneficiary. If the beneficiary is the spouse, the cash value portion that could have been rolled into an IRA is subject to income tax. If the spouse is not the beneficiary, the cash values paid to the beneficiary will also be subject to income tax. Alternatively, the cash values could have stayed in the plan (if the plan has continuity) and qualified for the minimum distribution stretch-out. If the QRP does not have a plan sponsor, the plan must terminate and the stretch-out will not be available.

Other Contracts

Business arrangements, such deferred compensation agreements, ESOPs, ownership interests in closely held businesses, and stock options, can create enormous wealth. The termination of a business arrangement may trigger a payout of the accumulated wealth. For example, when employment terminates, payment may be required under a deferred compensation agreement. When a shareholder of a closely held business dies or terminates employment, buyout payments may be required. How and to whom a payment is made depends upon the specific wording of each contract, but corporate lawyers generally draft such contracts without regard to estate planning issues. These arrangements, like the beneficiary designations discussed above, must be carefully analyzed so that any payments are consistent with the individual’s overall estate plan.