There has always been confusion between the terms, trusts, probate and beneficiaries. How are they used? What are the advantages and pitfalls? In this posting, I want to discuss beneficiary designations and appropriate ways of caring for this subject.
- What is probate? Probate is the legal process, which can be lengthy and expensive. Before any property can be passed to an heir or heirs, there are documents which need to be filed and executors which need to be appointed.
- One advantage of naming a beneficiary is that proceeds are IMMEDIATELY paid to the recipient without having to go through the probate process. Any insurance policy, annuity, or tax sheltered retirement plan (IRA, SEP, 401(k), TSA, etc) has the opportunity to name a beneficiary, and this chance should not be overlooked.
- Do not make the estate the beneficiary of your IRA, annuity or retirement plan. By making the estate the beneficiary you make a non-probate item, probate-able. It is a classic and common error and one which should never occur. To give you a hypothetical example: Jane is the beneficiary of her aunt’s estate. Included in the estate was an IRA worth over $2,000,000. The attorney named the estate as the beneficiary of the IRA and Jane. By doing this, he needed to liquidate the IRA before it was paid to her. It is possible, due to taxes and fees, over 60% of the IRA would shrink before it was transferred. Conversely, if Jane was named as beneficiary, the TOTAL amount would have been passed to her, tax free, and she would have to take distributions according to IRS tables. This error could cost Jane well over $1,000,000.
- What is a Transfer on Death (TOD) designation? A TOD designation is available in most states, and is used on accounts which, typically, do not offer the opportunity to name a beneficiary. For example, a “non-qualified” (meaning a non retirement plan) brokerage account which is in an individual name. For example, Mary would add her child(ren) as TOD recipient(s) of her brokerage account. These assets would transfer automatically upon Mary’s demise without having to go through the probate process.
- Consider using a TOD designation instead of joint ownership if you are a widow or widower. One mistake made by consumers is to name a child as a joint owner of an account (bank or brokerage) in order to avoid probate. Follow along with this example. Mary adds her daughter Susan as the joint owner of her bank account. Mary’s sole intention for doing this is to make sure the account does not have to go through probate and to give Susan access to her funds in case of emergency. The purpose was not for Susan to use this account as her personal ATM. Unbeknownst to Mary, Susan had gotten herself into financial difficulty, and the proceeds of this account were used to settle her debts. By making her daughter joint owner of the account, she now exposed this asset to her daughter’s creditors. The use of the TOD designation allows for the consumer to continue controlling the asset while making sure it passes promptly upon their demise.
- How does a trust avoid probate? By naming a trust as beneficiary, all proceeds are paid to the trust, and the trust document will determine in which manner the proceeds are paid. Trusts are an extension of the grantor’s wishes, and many powers may be given to the trustee to grant them additional discretion. By their general nature, all trusts avoid probate.
Conclusion. Any estate planning questions should be directed to a competent estate planning attorney who will work in conjunction with your tax professional and investment advisor to formulate the proper and correct strategies for your estate.