Naming a beneficiary on your various accounts can be one of the most important steps to a solid estate plan.
Wait. I thought having a Will or Trust was the most important thing.
Wills and Trusts (along with other estate planning documents) are important for sure but did you know that a beneficiary named on your accounts or life insurance can supersede one’s wishes in their estate planning documents?
It’s true. Let’s say your Will says, “I leave everything in my estate to my brother Mortimer”.
However, your sister Penelope is listed as the sole beneficiary of your IRA.
Mortimer does not receive the IRA assets.
So, therefore, it is imperative your estate plan coordinates any beneficiaries listed on your various accounts.
Now that we know that, does it matter which person or entity is named on a particular account?
It could. Here is an example of different types of accounts and different beneficiaries.
- Roth IRA worth $500,000
- Traditional IRA worth $550,000
- Life Insurance worth $1,000,000
- Bank Account worth $250,000
- Deferred annuity worth $700,000
- Your sister the neurosurgeon
- Your brother the starving artist
- Your church
- Your 55-year-old son going through a divorce
Assuming your desire is to leave money to everyone on this list, does it really matter who gets what?
It can. Different types of assets have different rules around taxes. For example, a Roth IRA left to an individual can be worth more than a traditional IRA. Why?
Well, money that comes out of a Roth IRA is generally 100% tax free (Assuming the Roth met certain guidelines) while a traditional IRA’s distributions are taxed as ordinary income to the recipient.
The amount one pays in taxes on the traditional IRA is based on their particular tax bracket.
Test Question #1. Would it be better for your sister the neurosurgeon to inherit your Roth IRA or your Traditional IRA? (Remember, the Traditional IRA is worth $50,000 more than the Roth IRA)
I gotta believe your sister is earning a very good income. Therefore, she is most likely in a high tax bracket, if not in the highest tax bracket.
Any dollar she takes out of the traditional IRA will be added to her ordinary income and be taxed as such.
Money coming out of the Roth IRA would potentially be tax free! Even though the account is worth $50,000 less, her high tax bracket could ultimately cause her to end up with less money after taxes if she took the traditional IRA.
Since the traditional IRA carries the highest potential tax burden, it might make sense to leave this account to the starving artist brother as he most likely is in a lower tax bracket.
What about the church? Should we leave them the life insurance or the bank account?
No. Since life insurance left to a beneficiary is tax free and a church pays no taxes, life insurance would be best to leave to a non-charity. (The bank account wouldn’t really be an income taxable asset either). Maybe leave the life insurance to the 55-year-old son?
Well, if he is going through a divorce and inherits any money before the divorce is final, 50% could go to the current wife.
If one wants to protect the assets from going to a spouse of a beneficiary (whether that divorce is happening soon, or you just don’t want to see money going to someone if a divorce happens down the road) there are strategies one can use to help prevent that. (Happy to chat one on one on this topic)
So, what is best to leave to the church? The annuity could be the perfect thing. Annuities basically work like this. You give an insurance company a lump sum of money to buy the deferred annuity. Let’s say you give them $400,000 and upon your death, it is worth $700,000.
The $700,000 goes to your named beneficiary BUT if they are a non-charity, they will pay ordinary income taxes on $300,000. Maybe the annuity would be a good gift to leave the church as they would pay zero in taxes.
As you can see, different types of assets have different values due to tax ramifications.
Different assets can also increase taxes in other areas. If one is on Medicare and inherits an asset that increases their income. Like that annuity or traditional IRA, their Medicare premiums could increase.
It is always best to sit with a Certified Financial Planner™ practitioner and estate planning attorney to help ensure not only your wishes will be carried out but also consider the tax ramifications to those left behind.
One last point. This blog touches on income taxes. Depending on the size of one’s estate when they pass away, there could also be estate taxes to pay.
Check out this other articles..
Have you inherited an IRA? Click HERE
Don’t Pay Taxes Twice Click HERE
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All the best.
Rick Fingerman, CFP®, CDFA™, CCPS®
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. FPS provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client after entering into an advisory relationship. Information herein includes opinions and forward-looking statements that may not come to pass. Information is derived from sources believed to be reliable. Information is at a point in time and subject to change without notice. Such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.