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Top 7 Mistakes Made on Beneficiary Forms in Estate Tax Planning

Mark Zaifman   |    Wed, Feb 23, 2011 @ 01:48 PM

estate-tax-planning

One night last week, when I was having trouble falling asleep, I watched Ed Slott, CPA on PBS presenting his annual income tax and IRA planning program. Although his presentation shtick is not my style, he does offer some excellent advice, particularly for baby boomers who may be designated as beneficiaries for their aging parents estates, while at the same time beginning to consider beneficiary choices for their own estate planning. (As a side benefit, Ed offers a natural and organic way to fall asleep.)

One item that really caught my attention was his warning about beneficiary forms. Like wills, living trusts and other estate planning tools, there is a lot of confusion surrounding this important aspect of comprehensive financial planning.

Perhaps one of the easiest tasks when it comes to estate planning is naming beneficiaries. Yet this simple task is very often where mistakes are made, much to the joy of ex-spouses, the IRS and tabloids angling for a nasty inheritance scoop.

The Top 7 mistakes made on beneficiary forms are:

1.      Thinking your will is going to take care of all the details

Beneficiary designations always trump what’s in a will. These documents must be consistent with one another. If you set up a trust, designate the trust as the beneficiary, not the person you named in the trust to inherit the money.

2.      Subjecting your heirs to an avoidable tax bill

Failing to name beneficiaries on your IRA(or consigning it to your estate) robs your heirs of the ability to maintain tax-advantaged growth over their lifetime (via a stretch IRA). Without a beneficiary, your IRA money will go through probate, and your family (excluding spouses) will be required to withdraw the money within five years. Most beneficiaries don't even wait that long: They take hold of the entire IRA at once. Doing so not only incurs an immediate tax bill, but also subjects all subsequent earnings and capital gains to income taxes. On a $100,000 inheritance earning $5,000 a year, anyone in the 25% tax bracket just bought themselves an annual tax bill of $1,250.

3.      Forgetting to update forms when life happens

Just as bad as failing to name a beneficiary is not updating designations when beneficiaries marry, divorce, come of age. Set a date when you will review/update all your beneficiary forms.

4.      Not having a Plan B

If your primary beneficiary isn't around to collect, and no secondary beneficiary is named, the court decides who gets the money. Be exact. You can name multiple primary and secondary beneficiaries, so don't be afraid to spell out how you want your assets divided.

5.      Naming minor children as beneficiaries

Until age 18 or 21 (depending on state laws), minors can only inherit limited amounts. Designate a financial guardian or set up a trust for the kiddos. Either should have detailed directions on how to manage the windfall until the children are of age.

6.      Keeping your plans a secret

Make copies of all your estate planning documents and tell your executor, financial advisor and loved ones where they're kept.

7.      Updating forms incorrectly

Marking up beneficiary forms and initialing your changes won't hold up in court. To override old designations, make changes in writing, and give a copy to the institution where the original is (hopefully) on file.

So in short, when you are preparing your estate planning documentation, remember to:

  • be consistent in your documentation,
  • name beneficiaries on your IRA,
  • keep forms updated when life changes happen,
  • choose a secondary beneficiary as a ‘Plan B’
  • choose a financial guardian for underage children,
  • distribute estate planning documents to those involved,
  • update forms correctly so they hold up in court if need be.

Estate planning is just one part of your overall financial plan - always consider your whole financial picture.