You can't take it with you, so who gets it?

By Terry Savage

You work hard for your money, and you want to make sure that it goes to the people you care about after your death. Yet one simple mistake could wipe out all that hard work -- and the legacy you hope to leave. The mistake is forgetting to name a beneficiary -- or naming the wrong beneficiary -- on your life insurance policies and retirement accounts.

If you fail to name a beneficiary on retirement accounts or life insurance policies, the proceeds of these accounts go to your estate. And if you fail to name beneficiaries for your estate through a will or living trust, the state probate court will distribute your assets according to state laws. Depending on the laws of your state, your living relatives and spouse (even if long-separated) will be dividing your assets. That's the best argument for creating and reviewing your estate-plan documents.

But life insurance and retirement plan assets can be distributed directly to those you name -- outside the probate process -- if you've given specific directions. Every IRA or company retirement plan asks you to name a beneficiary. When you purchase a life insurance policy, you'll be required to name a beneficiary. Even when you receive life insurance as part of your company benefits plan, you'll be asked to name a beneficiary.

Name the right beneficiary

Your first step is to make sure you've actually named the right beneficiary. This small form might be easily overlooked, especially for IRAs established many years ago or for rollover accounts, Check with your employee benefits manager and IRA custodians, as well as life insurance companies, to make sure they actually have the signed forms.

Most people give the process of naming a beneficiary very little thought. It's easy to write down your spouse's name. And it's easy to forget to change your beneficiary after a divorce. Or you might want the insurance proceeds to go toward your child's college education. So you simply fill in the child's name as beneficiary. Perhaps you're worried about taking care of elderly parents, so you name them as beneficiaries of an insurance policy or retirement plan. All these are common errors that can cost big money -- and peace of mind.

While you're at it, think about contingent beneficiaries -- the recipients of your estate if your primary beneficiary is dead. The same standards you use for naming your primary beneficiary should apply with the contingent beneficiaries as well.

Don't name a minor child

One of the biggest mistakes is naming minor children as beneficiaries or contingent beneficiaries of an insurance policy. Yes, the proceeds are intended for their benefit, but a minor cannot legally hold assets in his or her name. Making this mistake can be costly.

Nancy Lyon, vice president of The Northern Trust Co. in Chicago, heads up a bank division that manages legacies that have been mistakenly left outright to minors and disabled adults. In those cases, the probate court is required to name a financial institution as guardian of the estate.

Lyon's group manages nearly $600 million at the direction of courts in the Chicago area alone. Some of the money comes from awards to minors in personal-injury lawsuits. At least half comes under bank management when people have died without naming legal trustees and then left estates, IRAs or life-insurance proceeds to minors.

Lyons notes: "It's not only the issue of having the courts get involved naming managers and guardians for these sums of money. Without direction from a parentally named trustee, the money must be distributed outright to the child at the age of majority -- age 18 in Illinois. That might not be the result that the parent had wanted."

While some of those 18-year-olds see the wisdom of retaining the bank or investment adviser originally named by the courts, Lyon says she's seen 18-year-olds walk out of the bank and head immediately for a new car dealer or walk down the aisle with an unscrupulous boyfriend. If you put the money in a trust, you can distribute the cash later on and let your child become used to the idea of managing the money. For example, you could set up a strategy to distribute one third at age 25, a third at age 30 and the balance at 35.

Possible Solution: Buy the insurance policy in the name of an irrevocable life-insurance trust, whose trustees will follow your instructions on investment and ultimate distribution of the proceeds. Or set up a testamentary trust that will be created on your death to hold the proceeds of the policies. (Remember: the proceeds of a life insurance policy aren't taxable to the recipient. At the same time, the policy would be considered part of your estate if you owned it when you died and could expose your estate to estate taxes. That's why many estate planners recommend that you own the policies on your spouse, and your spouse own the policies on you.)

You can state in the terms of the trust how you want those policies distributed. Of course, you'll need an attorney to handle the documents. That may cost a few dollars now, but think of the money and hassles it could save in the future.

Note that proceeds from a policy owned by an irrevocable life insurance trust are not included in your estate for federal estate tax purposes. Assuming there will be an estate tax in the future, and that your assets may grow to the taxable level, the irrevocable trust may be the better choice.

Think twice about naming your spouse

Most people name the spouse as beneficiary of life insurance or retirement plans. And in most cases, that's perfectly fine -- as long as you remember to change the beneficiary after a divorce! But naming a spouse as beneficiary of an IRA could limit your flexibility to pass that money on to future generations. If you have other assets outside the retirement plan that could be given to your spouse, you could name an adult child or grandchild as beneficiary of an IRA.

If you die before you've started taking distributions, your beneficiary would have to start taking distributions by the last day of the year following your death. But those distributions could be stretched out over the beneficiary's lifetime, giving the account many years to grow. In this case, time is more valuable than money. But it is only a good strategy if a surviving spouse is provided for in other ways.

In fact, while you're still contributing to a company retirement plan such as a 40l(k), you may be required to provide a waiver, signed by your spouse, if you name someone other than your spouse as primary beneficiary of the plan. But once you roll over into an IRA, you can make your own choice of beneficiary.

Remember that even though retirement plan or insurance assets pass directly to the beneficiary, without passing through the legal process of probate, those assets are still considered part of your estate and possibly subject to estate taxes. So they should be dealt with as part of the entire estate -- and estate tax -- planning process.

Possible Solution: Divide your IRA rollover account into several individual accounts, naming a different beneficiary for each. You'll still have to consolidate the total assets to figure out your required minimum withdrawals, but each account will pass separately to your named beneficiary at death.

What about naming parents?

If you're a young, single person just starting out, it may make sense to name your parents as beneficiaries of your retirement plan or the life insurance you receive at work. But as your retirement plan grows and as your parents get older, you should think the question through again. If your parents have ample estates, they won't need the money. In fact, it might push their estate into a taxable bracket and send much of this windfall to the IRS when they die. On the other hand, if they have few assets or income, inheriting some money from you could disqualify them from receiving some federal or state benefits, such as coverage for nursing home costs.

Possible Solution: If you still want to leave insurance proceeds or retirement fund assets to care for your parents, set up a trust to become the beneficiary. Then instruct the trustees to provide your parents with the care you want. Any remaining balance could go to other relatives or even to a charity. Again, check with your attorney about drafting this trust, so the assets cannot be counted against your parents in Medicaid planning.

The bottom line

That signature line for naming a beneficiary, and subsequent contingent beneficiaries if the one named first is no longer alive, is a very short line. But it's a very important one. Usually, it's easy to change the beneficiary on an insurance policy or retirement-plan account. Few companies even require a notarized signature. So check your accounts for beneficiary designations right away. You don't want to leave your money to your least-liked relative -- your Uncle Sam!