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Hopefully you are one of the estimated 20% - 40% of Americans who already have a will. If you are, you may think you have done all that you need to do to ensure that your assets pass as you wish at your death. Unfortunately, you could be very wrong.

Your will will govern the disposition of your "probate" assets at your death. Historically, most assets were probate assets. However, over the years "non-probate" have grown, such that for many people they form the great majority of their assets.

A non-probate asset is an asset that does not pass under the will. For example, if an asset has a named beneficiary, that asset will pass to the beneficiary at the owner's death, rather than to the persons named in the will. These type of assets include life insurance and retirement plans, two significant employee benefits.

When you enrolled in your company's employee benefit plan, you would have completed an enrollment form. This form would have included a beneficiary designation. You may have completed this form many years ago and not thought about it since then, and that could be a disaster from an estate planning perspective.

For example, assume Bob completed the beneficiary designations for his life insurance and 401(k) plan ten years ago when he was married to Sue and had one child, Mary. Bob named Sue as the primary beneficiary of his insurance and retirement plan, and he named Mary as the contingent beneficiary. Bob and Sue later divorced.

Today, Bob is married to Kathy and they have a son, Tim. Bob wants his assets to pass to his two children at his death, so he signs a will which provides for such a distribution. Bob dies. Who receives his assets? Sue, his ex-wife, will receive his life insurance and Kathy, his current wife will receive his 401(k). This is true even though Bob's will provides that everything passes to Mary and Tim.

Bob designated Mary as the beneficiary of his life insurance and his 401(k) plan and never changed the designation. Some states have laws providing that a beneficiary designation naming a spouse is automatically terminated in the event of divorce. Illinois does not have such a law. Therefore, Sue is still the valid beneficiary of the life insurance. Would the result change if Sue and Bob's divorce decree awarded the life insurance to Bob? It would depend on the terms of the decree, but probably not. Awarding the insurance to Bob simply means that he owns the insurance and he is free to name anyone he wishes as beneficiary. In our example, Bob did not change the beneficiary, so Sue receives a windfall.

Kathy will receive the 401(k) because federal law provides that Kathy must be named as the beneficiary of the 401(k) unless she waives this right in writing. This would be true even if Bob signed a new beneficiary designation naming Mary and Tim as his only beneficiaries – unless Kathy agreed to the new designation in writing. Would the result be different if Bob and Kathy had a premarital agreement providing that the 401(k) was Bob's non-marital property and that Kathy waived her rights in the 401(k)? Surprisingly, no. Only a spouse can sign a waiver under federal law. Therefore, any document that Kathy signed before the wedding will not be sufficient.

Now assume that Bob leaves his job and rolls his 401(k) into an individual retirement account, naming Mary and Tim as the beneficiaries. What happens to the IRA at Bob's death? It passes to Mary and Tim. The federal law requiring that Kathy be named as the beneficiary only applies to employer-sponsored retirement plans and not IRAs.

What if Bob named his estate as the beneficiary of his life insurance and his IRA? Then the proceeds would become probate assets and be distributed by Bob's executor as provided in his will. Although this may seem like a simple solution, it is almost never a good idea.

If Bob names his estate as the beneficiary of his IRA, his children will lose the ability to continue to defer income taxes on the IRA. If Bob names his estate, the IRA assets must be distributed to the estate, and the estate will pay income taxes on the entire distribution. However, if Bob names Mary and Tim as the beneficiaries, they will be able to withdraw the IRA proceeds over their own remaining life expectancies, allowing the income tax on the IRA to be deferred over many years.

Paying life insurance to an estate does not have the same income tax consequences as paying a retirement plan to an estate because life insurance proceeds are generally not subject to income tax. However, naming an estate as the beneficiary of a life insurance policy or a retirement plan may cause the proceeds to be reachable by creditors. Assume Bob owes $50,000 in credit card debt at his death and has no assets other than his life insurance and IRA. If Bob names Mary and Tim as the beneficiaries of the life insurance and the IRA, there will be no assets in his estate, and the credit card debt will be eliminated. However, if Bob names his estate as the beneficiary, the life insurance and the retirement account may be reachable by the credit card companies.

So, what is the answer? You need to be pro-active when it comes to your estate plan. If you don't have a will, get one as soon as possible. Also, review all of your beneficiary designations as soon as possible. Make changes as necessary. If you have questions regarding the beneficiary of your retirement plans, talk to your tax advisor. Review your designations annually and any time you have a change in your family – marriage, divorce, the birth or adoption of a child, a death, etc. Most of your estate may be composed of life insurance and retirement plans. Take the time to ensure that they pass as you wish.
Posted in: December, 2007
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