Estate as Beneficiary of Life Insurance, IRA or 401k: Bad Idea
The last place you want your life insurance, retirement account, or pay-on-death (POD) account to go upon your death is to your Estate. Thus, do not name your “Estate” as the beneficiary on the designation form provided by your insurer, broker, or financial institution. However, even if you don’t make this mistake on the designation form, the Estate can still end up being the beneficiary. For instance, if you fail to designate any beneficiaries, the funds are paid to the Estate. Also if the beneficiary you designated has already died, the funds are paid to the Estate. This is why naming contingent beneficiaries is so important. There are three main reasons to keep these funds out of the Estate.
1. Availability of Funds
One of the major advantages to life insurance, IRAs, and POD accounts is that the funds are usually made available to the beneficiaries quickly. Typically all a beneficiary needs to do is complete a simple form and provide a death certificate and checks are issued directly to the beneficiary. This can be particularly advantageous when these funds are needed to support loved ones immediately after your death.
If the Estate ends up being the beneficiary, the checks are made payable to the Estate. This means that someone will need to open up an Estate in order to do anything at all with the checks. The process of opening the Estate, administering it, and ultimately distributing the assets will take much much longer. The funds could be tied up for months or years during this process.
2. Creditors
Funds payable to beneficiaries from life insurance, IRAs, and POD accounts are the property of the beneficiaries. Thus even if the decedent had $100,000 in medical bills owed at the time of his death, the $100,000 insurance policy payable to his wife goes directly to his wife. The decedent’s creditors have no claim against the $100,000.
However, funds payable to the Estate are the property of the Estate. As such, if the medical providers filed valid claims against the Estate, the funds must first be used to pay creditors claims before any distributions to heirs. Thus in the above scenario, the life insurance proceeds would be used to pay the outstanding medical bills with nothing left over for the surviving spouse.
3. Stretch IRAs
If a person (not an Estate) is a beneficiary of an IRA they may be able to elect to keep the money in the inherited IRA and continue to let it grow tax deferred. This is sometimes called a stretch IRA (also known as legacy IRA, extended IRA, etc). Each year, the beneficiary will have to take out a “required minimum distribution,” but will be able to leave the rest growing in the IRA. For younger beneficiaries, this can be the start of a retirement plan. For older beneficiaries this can be an excellent way to supplement their own retirement plan.
If the IRA is payable to the Estate, taxes must be paid and the funds must be removed from the IRA. The Estate then will use the funds, along with any other Estate assets, to pay administration expenses, creditors claims, and eventually the remainder, if any, is paid to the heirs.
