From the January 2004 issue of Investment Advisor • Subscribe!

Getting It Right

You'd be surprised by the number of incorrect beneficiary designations out there. Here's how to help clients avoid this pitfall

Do your clients have incorrect beneficiary designations? Sadly, the answer is probably yes. One leading tax authority and industry analyst estimates that 75% to 80% of account forms have incorrect or outdated beneficiary designations.

Many advisors overlook the serious financial implications that beneficiary designation errors can have on an estate. Errors in the naming of beneficiaries can lead to the disinheritance of children and grandchildren, and delays in providing for the financial needs of loved ones. They may also result in unnecessary expenses and tax payments that can significantly reduce the value of an estate. Oddly enough, the reasons why the wrong individuals end up as beneficiaries are both easy to understand and easy to avoid. There are three main reasons:

o Life changes, including marriage, divorce, death, or birth of a child

o Negligence in naming and updating beneficiaries

o Ignorance of the entire issue

In fact, industry studies have shown that the majority of the emerging affluent market fail to review their designations on an annual basis.

Sometimes a simple strategy can have a profound impact on building a successful practice. A financial advisor who actively works with clients to make sure that correct beneficiaries are named can directly influence the preservation and tax-efficient transfer of estates to the rightful heirs.

Estate planning experts have identified four common errors made when naming a beneficiary:

o Failing to update beneficiary designations

o Naming an estate as beneficiary

o Owning assets jointly

o Failing to name a contingent beneficiary

Helping clients avoid these mistakes can generate significant goodwill that provides alert advisors with new opportunities to gather assets, sell more annuities and life insurance, and enhance their reputations as trusted advisors.

Failing to Update Beneficiaries

The impact of naming the wrong beneficiary is evident in the U.S. Supreme Court case decided in March 2001 of Egelhoff v. Egelhoff (532 U.S. 141). Mr. Egelhoff designated his second wife as the lone beneficiary of a life insurance policy and his employer-sponsored pension plan. Shortly after divorcing his second wife, and prior to making changes to his beneficiary elections, Mr. Egelhoff died. The ex-spouse, from the second marriage, was the rightful beneficiaryof the proceeds from both his life insurance policy and his pension.

Mr. Egelhoff's children from his first marriage sued his second wife to recoup assets they believed should have been theirs. However, the Supreme Court held that the second wife was the rightful beneficiary, and the proceeds of his life insurance policy and retirement plan assets went to her. The children got nothing.

After his divorce, Mr. Egelhoff should have determined whether his children should be named as beneficiaries in place of his ex-wife. It would have taken only a few minutes to make the required changes, and he would have insured that his children received the estate. Failing to insure that clients update the beneficiaries named in their financial accounts can lead to serious unintended consequences.

Naming an Estate as Beneficiary

In reviewing your clients' investment accounts and life insurance policies, it is very likely that you will see their estate named as the beneficiary. Unfortunately, naming an estate as beneficiary may cause the inheritance your clients intend for their loved ones to be subject to added expenses and delays and, potentially, the public scrutiny associated with probate.

A study conducted by the National Network of Estate Planning Attorneys about 10 years ago, but which is still accurate, identified two disturbing facts: The average length of probate is between one and two years, and the average cost of probate ranges from 3% to 10% of the value of the gross estate, thereby reducing the proceeds received by heirs. Additionally, assets subject to probate may not be transferred to the intended person, in the intended amount, or at the intended time.

When assets invested in individual retirement accounts (IRAs) are left to an estate, as much as 70% of the proceeds may be consumed by taxes upon the death of the owner. The primary reason for this dramatic reduction is that an estate can neither stretch out distributions nor defer taxation. Think about the implications of those restrictions. With such a large percentage of IRA assets potentially lost to estate and income taxes, advisors need to be sure they address this issue with clients.

Many clients who name their estate as beneficiary believe that their last will and testament is the best way to pass assets on to the next generation. But given the problems described above, it may make sense to purchase annuities instead. An annuity allows beneficiaries to be fully--and correctly--named, as well as allow for the rapid transfer of assets to named beneficiaries without the need to go through probate.

Consider the following hypothetical example. A grandfather with a significant amount of assets wishes to transfer his investment accounts to his six grandchildren. If he names the estate as beneficiary, then the six grandchildren may be forced to wait for months, or even years, to take possession of the assets. In the process, his heirs will likely see the proceeds of these accounts reduced by probate costs and taxes. On the other hand, by establishing separate annuity contracts for each grandchild, and naming them individually as the beneficiary, the grandfather controls how much will go to each individual, and is guaranteed that the asset transfer will not be delayed or diminished by probate.

Jointly Held Assets

Another significant problem arises when assets are held jointly, as they often are with married couples. When spouses leave their assets to each other, this is known as a "poor man's will."

The transfer of jointly held property by married couples can become a nightmare because of myriad unanticipated problems, including the payment of unnecessary estate taxes. In 2003, there is a unified credit available to each taxpayer that can offset up to $345,800 in estate taxes. The unified credit allows each taxpayer to transfer $1 million of property (increasing to $3.5 million in 2009) free of federal gift and estate taxes during lifetime or at death. If a deceased spouse leaves all jointly held assets to the surviving spouse, there are no estate taxes due at that first death based on the unlimited marital deduction.

However, since the couple did not divide ownership of their assets, name separate beneficiaries for their assets, or individually utilize the unified credit, unnecessary estate taxes may have to be paid at the second spouse's death unless the second spouse's estate is worth $1 million or less.

In addition, jointly owned assets could result in children being unintentionally disinherited. The surviving spouse can give away or bequeath at death the property to anyone he or she wants, regardless of the desires of the deceased spouse. This loss of control is far more likely if a spouse remarries, or if there are children from a previous marriage.

Assets held jointly by unmarried individuals can also cause significant financial problems. For instance, there is a possibility of double federal estate taxation. In the following hypothetical example, Frank has a $1 million mutual fund account. He wants his son, Frank, Jr., to eventually inherit the account. He adds Frank, Jr.'s name as joint owner with right of survivorship. The entire asset will be taxed in the estate of the first to die--except to the extent the survivor can prove contributions to the asset. In this case, Frank, Jr. will not be able to prove he contributed to the account, so the full $1 million will be taxed. If Frank, Jr. includes all, or a portion, of these assets in his estate, they will be taxed a second time when he dies. And gift taxes may result if only one individual provided the asset.

Need for Contingent Beneficiary

Another very common error people make is to name only one beneficiary. Naming a second, or contingent, beneficiary can prevent future financial headaches. If an investment account owner named only a primary beneficiary, and the beneficiary dies before him, then the account proceeds will be paid to the estate. This may create serious estate tax issues, lead to probate, and cause the same asset transfer problems described earlier. Had a contingent beneficiary been named, these problems could have been avoided. A good guideline to follow is the "Rule of Two." Name two backups for every person named on the account as a beneficiary.

Do your clients know if their beneficiary designations are accurate? The time you invest working with them to find out the answer to this simple question will pay significant dividends for all parties involved. After reviewing your files, compile a list of clients who you believe need to review their beneficiary designations, particularly those who have recently experienced a life-changing event. Be proactive and schedule an appointment for them to come to your office. Ask them to bring in copies of all account statements so you can conduct a comprehensive review of their financial plans and beneficiary designations. A five-minute meeting with your clients can help save them thousands of dollars and preserve the integrity of their long-term financial plan. It can also deepen your relationship with them and lead to new clients from the next generation.

Greg Salsbury, Ph.D., is an executive VP for Jackson National Life Distributors, Inc., in Denver. He can be reached at greg.salsbury@jnli.com.

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