As defined by Wikipedia, “in the social sciences, unintended consequences (sometimes unanticipated consequences or unforeseen consequences) are outcomes that are not the ones foreseen and intended by a purposeful action.” I don’t know if Robert Merton, founder of the sociology of science, had it in mind when he developed and popularized the term in the twentieth century, however, it’s clearly applicable to estate planning.
A monumental moment in many individuals’ lives occurs when they finally meet with, and engage the services of, an estate planning attorney. This isn’t an easy thing to do as evidenced by the fact that more than half of U.S. adults don’t have a will.
For those who take the plunge, it’s important that this is followed up with periodic reviews with an estate planning attorney and financial professionals to discuss potential changes to an estate plan whenever there are any major life-changing events. These include birth, death, marriage, divorce, career changes, and major health events.
Wills and Living Trusts are Part of an Estate Plan
Without discussing the purpose of wills, living trusts, and other estate planning documents, suffice it to say that while the beneficiaries named in these documents generally control the disposition of assets at the time of death, there are several situations where they don’t apply. These include participants in retirement plans and owners of life insurance and annuities.
Whether you’re a participant in a retirement plan or own a life insurance policy or annuity contract, a beneficiary form is used to name primary and contingent beneficiaries. While they may be identical, the beneficiaries and percentages specified on beneficiary forms supersede those in wills, living trusts, and other estate planning documents. Copies of current beneficiary forms should be retained in an estate planning file that includes your other estate planning documents.
Trust and other non-standard beneficiary designations are often appropriate for estate planning documents and beneficiary forms where there are children who are young, have special needs, struggle with substance abuse problems, or are otherwise not good candidates for inheriting assets outright. Coordination of designations between wills, living trusts, and retirement plan, life insurance, and annuity beneficiary forms in light of the various assets and values to which they apply is essential.
Enter Unintended Consequences
As you can imagine, a fair amount of time and expense is devoted to litigating beneficiary issues in probate court. This is often associated with unintended consequences related to erroneous or outdated beneficiary designations that surface after death.
Unintended consequences are possible when contingent beneficiaries aren’t named, are improperly named, or when a primary or contingent beneficiary has passed and a beneficiary form hasn’t been updated with a replacement beneficiary. Sometimes the mistakes can be corrected after death; however, this generally isn’t the case. This post discusses two types of situations that present opportunities for unintended consequences related to beneficiary form designations.
Former Spouse Beneficiary of 401(k) Plan and Life Insurance Policy
One type of unintended consequences scenario can occur when a divorcee dies and never changed the beneficiary designation of a retirement plan, life insurance policy, or annuity contract from his/her former spouse to another beneficiary. There have been two Supreme Court cases in the last eleven years that have addressed this situation.
The first case, Kennedy vs. DuPont, which was decided in January, 2009, ruled that the beneficiary, who was a former spouse, was entitled to the 401(k) plan since it is an ERISA-covered plan that’s governed by federal law. Under ERISA, a spouse always receives half the assets of a qualified retirement plan unless he/she has completed a spousal waiver and another person or entity is listed as a beneficiary.
The second case, Sveen v. Melin, which was decided in June, 2018, upheld Minnesota’s revocation upon divorce law which has been adopted in twenty-six states. Under this law, there’s an assumption that a decedent intends to terminate all connections with his/her ex-spouse. In this case, it was decided that the former spouse, who was the primary beneficiary of a life insurance policy, wasn’t entitled to the proceeds and they were instead payable to the contingent beneficiaries.
Although Case #2 didn’t result in unintended consequences since it was determined that the former spouse wasn’t entitled to the life insurance proceeds, expensive and prolonged litigation was required in order to obtain this result. Furthermore, litigation was necessary despite the fact that Minnesota has a revocation upon divorce statute.
Estate as Beneficiary of a Retirement Plan
A second type of event related to beneficiary form unintended consequences can arise when it’s determined that an estate is the beneficiary of a retirement plan. This can occur when (a) there’s no beneficiary designation and no surviving spouse or (b) the individual who is named as the primary beneficiary is deceased and there are no named contingent beneficiaries.
Whenever a retirement plan participant dies without an effective beneficiary designation, the terms of the retirement plan or IRA agreement need to be reviewed. Qualified retirement plans such as 401(k) plans are subject to ERISA. The default beneficiary for these types of plans is generally the employee’s surviving spouse if applicable or the employee’s estate. Most IRA’s also provide that benefits are payable to one’s estate whenever there’s no surviving spouse and no effective beneficiary designation.
If an individual is the beneficiary of a retirement plan, he/she is considered to be a “designated beneficiary.” A designated beneficiary is entitled to defer distribution of inherited retirement benefits by withdrawing them gradually over his/her life expectancy under IRS’ minimum distribution rules.
An estate cannot be a designated beneficiary since it isn’t an individual. As such, it cannot take advantage of the life expectancy minimum distribution rules. Instead, there are two rules that apply in this situation, both of which are less favorable. This often results in unintended consequences when there are non-spouse beneficiaries and sizable retirement plan assets. The two rules are as follows:
- If the decedent died before his/her required minimum distribution date, all benefits must be distributed by the end of the year that contains the fifth anniversary of the date of death (the five-year rule), or
- If the decedent died on or after his required minimum distribution date, all benefits must be distributed in annual installments over his/her life expectancy had he/she not died.
The five-year rule is typically reduced to an immediate lump-sum payment in the case of 401(k) plans since installment payouts generally aren’t offered by these types of plans. As such, 100% of the value of the plan is subject to taxation in the year that it’s distributed.
In addition to being able to take advantage of the five-year rule, an executor of an estate can potentially set up inherited IRAs in the names of children as successor beneficiaries of a decedent if the IRA provider permits this type of transfer. Each child can then take distributions from the beneficiary IRA over his/her expected life expectancy.
Periodically Review Beneficiary Forms
An estate plan needs to be reviewed periodically during an individual’s lifetime to ensure that distributions will be made to intended beneficiaries upon death. A crucial part of the review is current retirement plan, life insurance, and annuity beneficiary forms since distribution of these types of assets isn’t controlled by the terms of wills, living trusts, and other estate planning documents.
As discussed, erroneous, incomplete, or outdated beneficiary designations can result in distribution of retirement plan assets, life insurance policies, and annuity contracts to unintended beneficiaries, unfavorable income tax consequences, and expensive and protracted litigation in some cases.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.