Do's and Don'ts for Beneficiary Designations

We pay good money to estate-planning attorneys to draft trusts and wills. We deliberate over which loved ones are best suited to be guardians for minor children in case of catastrophe. We have heart-to-hearts with our loved ones--though probably not as much as we should--about our attitudes toward nursing homes and end-of-life care.

At the same time, many of us approach beneficiary designations with barely a thought. We often make our choices as we're contending with a pile of other paperwork when we start new jobs and have a lot of other important decisions to make, like which healthcare plan to choose or how to allocate the 401(k). And because beneficiary designations don't pop up on our screens when we check up on our portfolios or receive statements, we may not revisit them for years.

Meanwhile, a lot in our lives may have changed since we made those original choices--marriages and divorces, births and deaths, relationships improved or turned sour. Alternatively, many of us make those designations without considering the financial, tax, and other ramifications--for our own plans as well as those of our loved ones. What many people don't realize is that those designations are binding and, in most cases, will supersede whatever is laid out in will or trust documents.

If you didn't give your beneficiary designations much thought when you first made them--or you made them years ago and a lot has changed since--it's time to revisit them. What follows are some do's and don'ts for beneficiary designations.

Do: Start with how you feel. Investors are always being lectured about how they shouldn't let their feelings get in the way of financially savvy decision-making. But guess what? Here's an area where you should use your emotional connection to people in your life as the starting point for thinking about the disposition of your assets. Who do you care about most and want to be financially secure? There may be a financial reason to not make those individuals your beneficiaries--for example, minor children or special needs loved ones, which I'll discuss below. But oftentimes the right answer is your nearest and dearest.

Do: Recognize the benefits accorded to spousal beneficiaries. In keeping with the above, most of us naturally want our spouses to inherit any assets we hold in our own names. But if you're unsure--for example, your spouse has a lot of his or her own assets but you're worried about your sister's financial well-being--bear in mind that spouses who inherit certain assets get special treatment in the tax code. That, in turn, often makes it advantageous for the spouse to inherit such assets ahead of other individuals. When it comes to inherited IRAs and 401(k)s, for example, only spouses have the opportunity to roll over those assets into their own IRA accounts. Likewise, spouses who inherit health savings accounts can roll over the HSA into an HSA account of their own. Because rolling those assets into their own accounts will enable the surviving spouse to take greater advantage of the tax benefits accorded those assets, it often makes sense to name a spouse as a beneficiary on them. This is also true for same-sex married couples, of course. Meanwhile, you could consider earmarking other assets, where spouses don't receive a special tax benefit when inheriting, for other loved ones--such as a taxable brokerage account.

Do: Make sure your beneficiary designations sync up with other parts of your estate plan. If you've taken additional steps on your estate plan beyond your beneficiary designations--for example, you've drafted wills and trusts--make sure your beneficiary designations sync up with the other aspects of your plan. It's a common scenario for people to make beneficiary designations first and draft other estate-planning documents later on when their families have grown. The former may contradict the latter, but the beneficiary designations will generally trump what's in the other documents, regardless of which paperwork was completed first. A good estate-planning attorney will typically cover beneficiary designations when setting up your plan, and will send you on your way with a packet of instructions about how to update your beneficiary designations to match the rest of your plan.

Do: Name contingent and/or partial beneficiaries. In addition to naming a primary beneficiary for a given asset, most beneficiary designation forms, whether electronic or online, give you the opportunity to name a contingent beneficiary--a backup beneficiary, if you will. So you could make your spouse your primary beneficiary, for example, and your brother the secondary beneficiary in case something happened to you and your spouse at the same time. In a related vein, you might also take advantage of the opportunity to divide a given asset among multiple beneficiaries. For example, you could designate both your brother and sister as 50% primary beneficiaries of your 401(k) plan, and name your favorite nephew and niece as 50% contingent beneficiaries each. Don't let yourself be limited by the number of lines on the form. Call your provider if you can't make your designations fit, and ask for written confirmation of your choices.

Do: Consider charities or other nonprofits. Many people think of humans when they think of beneficiaries, but charities and nonprofit educational institutions can also work well as beneficiaries. If there's an embedded tax gain in the asset--such as a 401(k) or IRA, for example--the charity or other nonprofit can avoid taxes on the whole amount. Here again, don't be limited by the number of lines on a form: You could give each of your two adult children 45% of your IRA, for example, but leave the other 10% to a charity that speaks to your heart. (Use a site such as GuideStar or Charity Navigator to be sure the charity uses funds well as it's doing good.)

Do: Make beneficiary designation checkups part of your portfolio review. You've surely heard the horror stories about the guy who inadvertently left his 401(k) to his ex-wife because he had failed to name his new spouse as his beneficiary, or mistakenly left his youngest with no assets because he hadn't updated IRA beneficiary designations after the birth of the child. Our life situations change, and so should our beneficiary designations, so be sure to revisit yours periodically.

Beneficiary designations can also fall through the cracks when you change financial providers--for example, if you roll over your IRA assets from one firm to another. This can also happen with employer-provided plans: If your employer or if your company has switched 401(k) providers, check to make sure your beneficiary designations have ported over along with your contribution rate and other choices you've made.

Don't: Leave assets to minor children without understanding what that means. Just as many married people want their spouses to inherit their assets, many parents naturally want their children to do so. Bear in mind, however, that minor children can't inherit assets outright.

If a child inherits a small financial asset--what counts as "small" varies by state--a parent or other guardian may be able to transfer the money into a UGMA/UTMA account or 529 plan, where it can grow until the child reaches the age of majority. That's not ideal for assets that had been in the confines of an IRA or 401(k) before, however, because UTMA/UGMA and 529 accounts have fewer tax lifetime tax benefits and may benefit less from compounding than is the case with inherited IRAs.

If you'd like to make a child the beneficiary of a financial account like an IRA or 401(k), a better idea is to make the child the beneficiary, then specify in your will the name of a custodian to manage the child's financial affairs until he or she reaches a specific age. (The custodian can be the same person as the child's guardian, or it can be someone else.) Alternatively, you could make a trust the beneficiary of your IRA; your trust documents, in turn, can spell out how that money is to be managed and distributed to your heirs. That might sound ideal, but setting up and managing trusts can be costly.

Don't: Leave assets to loved ones with special needs without considering the ramifications. If you have a special needs loved one in your life, as I do, you probably feel a pull to make sure they have everything they need and then some. Bear in mind, however, that there could be complications if a loved one with special needs inherits assets from you. You could affect the disabled individual's eligibility for government-provided benefits by transferring assets directly to him or her. In addition, if the person has an intellectual disability, he or she may not be able to manage the assets.

If you're in a position to transfer a large amount of assets to a loved one with special needs, consult with an attorney who specializes in estate planning first. He or she may recommend that you set up a special needs trust.

Don't: Designate to someone who's not the end owner. When I was a young singleton making my initial beneficiary designations, I made one of my dear sisters the beneficiary of my 401(k), with the assumption that she would know that I'd want her to split the money equally among all of our siblings. I later found out that delegating my beneficiary designations to her--rather than spelling out my decision on the form--was a bad idea. Not only would she not necessarily remember what she was supposed to do with the money, but she would not be legally required to split the assets equally among our siblings. In addition--and this is less relevant today given that the estate tax threshold is so high--if she were to inherit a big pot of money from me during her lifetime, that could create estate-planning headaches for her. Bottom line: Be as specific as possible on beneficiary designations. If I wanted each of my five siblings to each inherit equal shares of my 401(k), I should have made each of them a 20% beneficiary.

Don't: Stop with tax-advantaged assets. Beneficiary designations for IRAs and 401(k)s get the most attention, probably because they're the largest asset pools in many households. But don't neglect beneficiary designations for nonretirement assets like taxable brokerage accounts. A transfer on death registration allows you to transfer such accounts to another individual upon your death, allowing the assets to avoid probate; a similar registration type--payable on death is available for bank accounts. Check with your financial provider to set up such a registration. If you'd like to leave taxable bank or brokerage accounts to multiple beneficiaries, it's smart to do so via your will rather than transfer/payable on death registration.

Don't: Make inadvertent beneficiary designations. In a related vein, older adults often add an adult child as a joint owner on their checking accounts to help oversee bill-paying. But there are a couple of big drawbacks. One is that the child has full latitude to withdraw from the account as he or she sees fit; the account would also be vulnerable if the child has issues with creditors. Finally, the child who's joint owner of a parent's bank account would own that account free and clear once the parent dies; that may or may not be what the parent wants.