A beneficiary designation on a financial account directs how the assets in the account will be distributed after your death. For instance, if Mrs. Smith names her two children as the beneficiary of her brokerage account, then Mrs. Smith’s two children will receive her brokerage account after her death. Mrs. Smith could also specify the percentage of the distribution she wants each of her children to receive; for instance, Mrs. Smith could designate one son to receive 40% of the brokerage account and the other son to receive 60% of the account.
When Mrs. Smith designates her sons as beneficiaries of her account, she is permitting that account to pass outside of the probate process. In other words, neither her last will and testament, if she has a Will, nor the intestate succession statutes, if she does not have a Will, govern how her the brokerage account will be distributed after her death.
Many people believe that probate is a complicated process and avoiding the process is a valid goal. For this reason, people believe that having beneficiary designations (or “payable on death” designations) on as many accounts as possible is the preferable course of action. But is it?
In my opinion, a beneficiary designation has limited utility. In certain situations, a beneficiary designation can add a real benefit. In other situations, a beneficiary designation adds no benefit and can be dangerous.
In some states, probate is complicated. For instance, in Florida and California, the probate process can be complicated. In New Jersey, the probate process is very simple. “Probate” in New Jersey is simply proving that the last will and testament is a valid, properly executed Will. Most Wills are valid and properly executed; accordingly, the probate process is extremely simple and takes about thirty minutes from start to finish. Probating a Will in New Jersey costs about $150. Avoiding something that takes thirty minutes and costs $150 is, in my opinion, not worth investing your time and money trying to avoid.
Since the probate process is so simple and very inexpensive and since beneficiary designations are used to avoid probate, a beneficiary designation must add value independent of its ability to help you avoid probate without causing harm. In many cases, a beneficiary designation does not meet these criteria.
It is easier to explain when a beneficiary designation is a good thing than to explain all the reason it could be a bad thing. A beneficiary designation is a good thing for retirement accounts. If Mrs. Smith names her two sons as the beneficiaries of her IRA, then her two sons can remove their share of the money from the inherited IRA over a period of ten years. If Mrs. Smith failed to name her sons as beneficiaries, then the sons would have to remove the money from the IRA over a five-year period. The quicker you remove money from a retirement account, the sooner you must pay income tax on the money. Deferring income tax is a benefit.
In addition, if Mrs. Smith names her sons as beneficiaries, the money in the inherited IRA account is entitled to creditor protection from any of the sons’ potential creditors; in other words, if her son has a judgment against him, the money in the inherited IRA account (while it remains in that account) may be protected from the son’s judgment creditor.
On the other hand, there are several instances when a beneficiary designation can be a bad thing. What happens if you name a beneficiary, and the beneficiary dies before you? Who receives that asset? The short answer is, who knows.
What if the beneficiary you name refuses to return the money he received to pay the debts of your estate and there is insufficient money to pay those debts? Your executor will have insufficient money to pay your debts, but the creditors will be demanding that the executor pay those debts, causing your executor to sue the person you named as beneficiary to have the named beneficiary return the money he received.
A beneficiary designation sounds like a good thing, and it certainly is simple to do. Many financial institutions almost insist that you name a beneficiary, but the reality is, in most instances, naming a beneficiary is a bad thing.