Understanding the Pitfalls of Beneficiary Designation Forms

By Debra M. Simon

SEPTEMBER 2006 - Many individuals have a sizable portion of their wealth in various retirement savings accounts, such as IRAs (including SEP IRAs, SIMPLE IRAs, and Roth IRAs), 401(k)s, and others. Decisions concerning beneficiaries of these accounts are major issues in estate planning due to the emotional ramifications of such decisions as well as the potential income tax and estate tax implications. Because these accounts pass to beneficiaries outside of a will, individuals rarely seek advice before filling out a beneficiary form, even though the forms often do not allow for certain choices; nor do they allow for beneficiary choices outside of the design of the forms. Additionally, account owners do not realize that the information provided may be interpreted differently than intended.

In general, forms used by many financial institutions are rigid in their format and interpretation. Historically, many financial institutions do not record information that does not strictly conform to their own forms. The account owner is often not aware that the records are remiss and that unintended consequences may result.

Multiple Beneficiaries

The basic problem with beneficiary designations results when an account owner names multiple primary or alternate beneficiaries. An owner often wants an alternate to be designated for a specific beneficiary. For example, an account owner might want the children of a particular child named as alternate beneficiaries if that child (their parent) predeceases the account owner. Many financial institutions, however, look to the alternate beneficiary or beneficiaries only when there are no primary beneficiaries alive. A review of forms of four major institutions found this issue in all of them. Sometimes the institutions disclose this policy on the form itself in small print or in separate explanatory documents. It is common for financial advisors selling the products not to point out this issue.

The breach between what the account owner expects and what the institution will do can be significant. For example, Exhibit 1 shows a common situation. An account holder has a spouse, three children (A, B, and C), and four grandchildren (D and E, children of A; F, the only child of B; and G, the only child of C). The account owner names his spouse as the primary beneficiary and the children as alternates. Under the federal Treasury Regulations, account owners are allowed to name second alternates; however, most forms do not go that far. Assume that the spouse of the account holder has a significant amount of money in an IRA, and that the spouse will not be named as a beneficiary. The primary beneficiaries become the children, A, B, and C. The account owner names D, E, F, and G as alternate beneficiaries with the intent that D and E are alternates for A, F is the alternate for B, and G is the alternate for C. Exhibit 2 illustrates the desired distribution if A were to predecease the account owner. If, however, the financial institution looks to the alternates only if there are no primaries surviving, then all of the IRA would go to B and C, as shown in Exhibit 3. This is contrary to the account owner’s intent that his grandchildren inherit for their respective parents. This same situation could occur when an account owner tries to leave nieces or nephews as alternate beneficiaries for siblings.

Representation and Per Stirpes

Many states are adopting the Uniform Probate Code. (New York, however, has not yet adopted it.) New Jersey’s Uniform Probate Law became effective in February 2005. The code contains a new term, “representation.” In the past, if bequests were made to children and grandchildren “per capita,” the assets were simply divided by the number of beneficiaries. If the bequests were made “per stirpes,” then the assets were divided at the primary beneficiary level and the children of primaries would divide their respective parent’s share. If bequests are to be by “representation,” or “per stirpes by representation,” which is the default for testamentary documents if they are silent, then assets are divided equally among the beneficiaries at each generational level. Studies around the country showed that the majority of the public think that per stirpes by representation was always the norm, when, in fact, it was not.

In the example above, following the account owner’s intent in the event of A predeceasing the account owner, D and E would divide their parent’s Qd share, receiving Qh each. If B predeceases the owner, then F, having no siblings, would inherit B’s entire Qd share. Under the representation or per stirpes by representation regimes that are now the default under the Uniform Probate Code, if there are no longer primary beneficiaries, the assets are divided equally at the next level. If two of the three primaries survive the owner, the results would be the same for per stirpes and for representation, as discussed above. If none of the primaries survive, then D, E, F, and G would each inherit Qf under per stirpes by representation. If two of the primary beneficiaries predecease the account owner, the results would change according to how many alternate beneficiaries exist (Exhibit 2 presented one such outcome). The results for the simple beneficiary form and the account owner’s intent are the same if both or none of the primaries survive the account owner. A scenario in which one or more of the primary beneficiaries predeceases the account owner is not an unusual one, and the differences between the distribution under a simple beneficiary form and under the Uniform Probate Code would be significant.

Another area where account holders are not aware of choices available to them on beneficiary forms is the area of charitable planning. Charitable planning through qualified accounts is a complex subject, beyond the scope of this article, but it is important that individuals with philanthropic goals realize that there may be significant tax advantages available by handling charitable objectives through beneficiary designations of savings accounts.

Sound Advice

Investors should be aware of the potential tax consequences of retirement savings accounts. Account owners must also be advised of the differences between per capita, per stirpes, and representation. Finally, account holders interested in philanthropic giving should be counseled on whether achieving these goals through beneficiary designations makes sense.

To protect their wishes, account holders should first review the policies on how the beneficiary designations will be handled by each financial institution. Second, if the form does not provide the desired interpretations, a separate letter should clearly set out the designations and how they are to be applied. The letter will carry more weight if it is either notarized or witnessed by a disinterested party. The institution’s beneficiary designation form should refer to the attached letter, and both sent together, with a return receipt. A copy should be kept with the account holder’s will so that the executor of the estate can monitor the final distributions. Under current regulations, executors are given certain flexibility to take measures such as spliting accounts to ensure that the decedent’s intent is satisfied.

Finally, the account holder should periodically request that financial institutions provide the beneficiary information on record for each respective account. Many people think of doing this if their financial institution has merged or changed, but the information can be missing even in institutions that have been stable for years. Ultimately, it should be the financial institution’s responsibility that the account owners are fully informed and understand the choices they are making.

Debra M. Simon, CPA, MST, is the founder of Simon Financial Services in Hackensack, N.J.