Beneficiaries Instead Of Probate: Use Caution

The term “probate” refers to the court process whereby a decedent’s assets are gathered together and, after the payment of the decedent’s debts, distributed to the decedent’s heirs. One way to avoid probate is through the use of beneficiary designations. The only assets that pass through probate are assets the decedent owned in his or her sole name without any beneficiary designations. Any asset that contains a beneficiary designation passes directly to the beneficiary without any court intervention. Life insurance is a classic example of an asset that passes directly to the beneficiary. Retirement plans (e.g. IRAs, 401ks) also usually pass to a designated beneficiary. Other examples are “pay on death” designations on bank accounts or investment accounts.

The beneficiary designations must be considered as a part of your entire estate plan. When drafting your Will you should be cognizant of the probate assets (i.e., assets which will actually be governed by the Will) and also the beneficiary designated assets that pass directly to the beneficiaries. For example, in your desire to treat your children equally, you draft your Will to split up the assets in equal shares between your children. Your desire for “equality” can be destroyed if you also have a large IRA that passes directly via beneficiary designation to only one of your children. Thus, it is imperative that when drafting a Will the beneficiary designations are considered.

It is also important to note that even though the assets pass directly to the beneficiary, these assets are still a part of the your taxable estate. The beneficiary designated assets will be counted, along with the probate assets, to calculate the total taxable estate. Often these beneficiary designated assets, such as life insurance, can be enough to cause the imposition of estate taxes. In Maryland, a $500,000 life insurance policy can turn an estate with a $600,000 house into a taxable estate.

In addition to the unexpected tax liability, the beneficiary designated assets can cause some unfair distributions. For example, let us say that your first child is the beneficiary of a life insurance policy which is about half of your total estate. Knowing this, you draft your Will and give your house, the bulk of your probate estate, to your second child. While this may seem like a fair distribution, it is fraught with problems.

First, what if at some later point you cancel your life insurance and don’t execute a new Will? Your first child has been disinherited. Second, what if the housing market takes a turn and the house, which is the primary part of the probate estate, is worth practically nothing at your death. Your second child is then effectively disinherited. Finally, most standard Wills indicate that the estate should pay all the inheritance and estate taxes prior to the distribution of the estate assets. In this scenario, your second child, inheriting under the Will, ends up paying all of the estate taxes and your first child, receiving the life insurance, will have no tax liability.

Stay tuned for Part Two – Beneficiaries to Avoid!

By David Galinis