If you’re like most people, your key assets are probably your home, your retirement account, and any life insurance you may have through your workplace or which you acquired on your own. My earlier blog post on naming beneficiaries broadly addresses the issues to look out for when considering who to designate as persons to inherit your retirement accounts and life insurance. This blog post will take a closer look at these two valuable assets, and the rules that regulate inheritance thereof.
As mentioned before, in New York state, beneficiary designations such as these operate outside and override any choices you lay out in your will or a trust. But don’t assume that everything goes automatically to your loved ones - the more you understand these rules of inheritance, the more empowered you’ll be in choosing and securing your beneficiaries’ inheritance.
Being married (whether for the first or second time) creates different rules for designating beneficiaries than if you are partnered but not married.
RETIREMENT ACCOUNTS — 401(K), 403(B), IRA
You should note that when someone inherits from these retirement accounts, they don’t get a check or cash. They have to roll the proceeds over into their own retirement vehicles or set up a new one to receive the inheritance. This means that they can only access the monies per withdrawal rules relating to such retirement accounts. Your financial adviser can tell you more.
If you’re in your first marriage — then federal rules designate your spouse as your automatic beneficiary of your 401K. The legislation that applies this rule is ERISA, which governs employer-sponsored tax-deferred retirement plans such as a 401K or 403B.
If you are divorced and now in your 2nd marriage — if your divorce settlement requires that your 401K beneficiary remains your former spouse, then you can not add your current spouse as a co-beneficiary of that 401K. The usual ERISA rules that make current spouses an automatic beneficiary are subject to the divorce settlement which takes precedence. One solution could be to get your former spouse to waive this term of settlement, in which case you can designate anyone to be your beneficiary, including your current spouse and children. Could you alternatively start a IRA to benefit your current spouse if your former spouse refused to sign a waiver (see below on IRAs)? Probably, but check with your financial adviser first.
If you have a life partner but the two of you are unmarried — interestingly, this gives you much more freedom. You can simply designate your partner or significant other to be your beneficiary, and also include your children as beneficiaries. Of course, this is subject to any divorce settlement involving your retirement accounts if you were previously married (as set out above).
IRAs — this retirement fund accumulation vehicle also gives individuals similar tax-deferred investment growth advantages but are not work-related. IRAs reside outside ERISA because you don’t set it up through your employer, but on your own (e.g. with a bank or financial adviser of a wealth management firm). If you own an IRA, you can designate anyone to be your beneficiary (or beneficiaries). Since IRAs do not automatically designate surviving spouses as beneficiaries, you need to make your spouse one if you intend for him/her to inherit the money in your IRA when you’ve passed on.
Failure to Designate Beneficiaries — what happens if you forget to make any designations? Then your retirement plan monies are considered to be part of your estate and get added to it when you pass on. Whether you have a Will (which has to go through Probate) or a Living Trust (which does not), your heirs do not get the monies directly and will have to go through a much more complicated (and possibly prolonged) court process before getting the funds.
You can designate your partner who is not your spouse - when you designate/nominate beneficiaries of your life insurance, you are not bound by any regulatory requirements. You can designate anyone you choose, including people who are not your spouse or partner or children. Life insurance is therefore one of the key assets that unmarried but partnered people can directly inherit. Be sure to update this designation if your former spouse or partner was a beneficiary.
If you designate no one, your partner gets no share — the life insurance benefit money becomes part of your estate, to be distributed by the terms of your Will or Living Trust, or in the case of dying intestate, according to intestate law applied by the Probate Courts. Unlike retirement funds, life insurance proceeds where they are designated to specific beneficiaries means that your beneficiaries receive a check from the insurance company which they can cash immediately. It’s the most direct form of inheritance, but you need to properly designate your beneficiaries. For obvious reasons, this kind of inheritance provides the most immediate financial liquidity to your loved ones upon your demise, provided you’ve designated them properly as beneficiaries. Life insurance proceeds are income-tax free as well, at the federal level and in New York state. The challenge for unmarried couples is that New York intestate law only recognizes spouses, which means that if you die intestate, your life partner does not receive any part of the death benefit. Again, the solution is to specifically designate him/her to be a beneficiary.
An irrevocable life insurance trust (ILIT) - It’s important to understand the distinction between what your beneficiaries inherit from your life insurance and what your estate pays in terms of estate tax on your life insurance. Let’s say you have a $1 million life insurance policy - upon your demise, your beneficiaries (e.g. spouse and children) receive the $1 million in cash free of income or gift taxes. But this $1 million is added to what is your “estate” - which can include other assets such as real estate, other possessions, etc. - and which is subject to estate tax at both the federal and state level. Your estate now has to pay tax on the life insurance, even as your beneficiaries receive the benefit proceeds tax-free. While most of us won’t meet the $22.8 million threshold (married couples) or $11.4 million (for individuals) for federal estate tax, depending on where you live, there is still state* estate tax to contend with. The solution could be an ILIT, which removes any life insurance benefit from the taxable estate by passing on ownership of the policy to the trust, with you remaining as trustee. Does an ILIT make sense for most people? Only if you believe that you are going to exceed your federal or state estate tax exemption limits. There are specific legal and tax rules relating to ILITs, so talk to me and your financial and tax advisers before you decide to set up one.
(*For 2019, New York State estate tax is levied on estates worth more than $5.44 million)
NOTE: It’s important that you consult your own personal financial and tax advisers as this estate planning law blog post is merely for educational purposes and what is set out here may not apply in your own specific situation. There are also crucial tax implications and withdrawal/rollover rules for inheriting these two types of assets — issues which your financial advisers can guide you on.