It is extremely important to have a will, and perhaps a revocable trust, that distributes your property to the people you want and in a manner that carries out your wishes. For many people, however, it is just as important – if not more so – to ensure that the beneficiary designations on your life insurance policies, retirement plans, and other assets reflect your wishes and are consistent with your overall estate plan. Those beneficiary designations will trump any contrary provision in your will, and using them correctly can save significant taxes for your estate and your beneficiaries.
Retirement plans are quickly becoming the greatest source of wealth for many Americans. One study indicates that 30% of household financial assets are in retirement plans. Whatever the number is in your particular case, it's important to pass that wealth to your beneficiaries as efficiently as possible. That means allowing your beneficiaries to maximize their tax-deferral opportunity. Here are some general principles to consider as you designate beneficiaries of your retirement plans.
Don't designate your estate as beneficiary. Similarly, don't fail to designate a beneficiary, in which case the plan's default beneficiary (usually your estate) will apply. When your estate is the beneficiary of your retirement plan, all plan assets must be distributed – and taxed – within 5 years of death. That means your beneficiaries will likely miss out on years of tax-deferral opportunity.
It's generally better to name individual beneficiaries directly, rather than naming a trust for the benefit of those individuals. There is some tax-deferral opportunity available even when a trust is the beneficiary, but it may not be as great as that for individual beneficiaries. Further, there are complex rules that must be negotiated in order to maximize the tax-deferral available to a trust as beneficiary. Better to avoid those altogether by naming individuals.
When naming individual beneficiaries, younger is better. Your beneficiaries will have to begin taking distributions from the retirement plan in the year after your death. The amount of those required distributions depends on the size of the account and the age of the beneficiary. Younger beneficiaries will be able to spread their distributions out over longer periods and defer tax for a longer time. For some people, it may make sense to designate grandchildren as beneficiaries of retirement plans, allocating generation-skipping tax exemption to avoid or minimize transfer taxes.
Finally, when a spouse is the intended beneficiary, it's almost always better to name the spouse directly, rather than a marital trust, as beneficiary of the plan. In addition to maximizing tax-deferral opportunity, naming the spouse directly will give him or her the option to treat the retirement plan as the spouse's own, which may allow the spouse to avoid taking any distributions until they reach age 70 ½.