October 2010 Topics
During the process of gathering information from my estate planning clients, I provide a questionnaire that asks questions on goals, financial situations, family relationships and the like. One of the questions asks the client to list the designated beneficiary and contingent beneficiaries on their financial accounts like IRAs, 401(k)s, brokerage accounts, etc. Many times the client says, "Well, it should be my spouse, but right now it is my parents because I didn't update it when I got married." I also commonly hear clients state that they have never updated their contingent beneficiary designations when a child was born.
Forgetting to update designations as their family structure changes is very common. A person should adjust their beneficiary designations when certain life changing events take place, most commonly:
After such a life changing event, a person should consider how the change impacts the ownership, relationship and disbursement of assets if that person should die.
- when a person gets married,
- when a person purchases a home,
- when a child is born,
- when a married couple gets divorced, or
- when a spouse dies.
With Americans getting married later in life, many single people
now acquire assets prior to getting married. For example, if a non-married
person purchases a house and subsequently gets married, there could
be an issue with respect to ownership of the home in the event the
purchaser spouse dies. More than likely, the non-married purchaser
bought the house without any joint tenants or tenants in common
January 2010 Newsletter.). If the deed is updated to reflect
the change in the purchaser's marital status, the house will have
to enter probate. It might not be a huge issue. For example, Virginia's
transfer of ownership during probate moves quickly. However, other
states are not as accommodating. But a more complicated situation
may occur. For instance, if the non-married purchaser listed one
or more parents on the deed as joint tenants, the house could go
to the deceased's parents under joint tenancy with the right of
survivorship rules. Or, the lack of joint tenancy of the home could
create an estate tax issue for the deceased. (See August 2010 Newsletter).
Another issue that impacts beneficiary updates is divorce and remarriage.
A divorce will normally negate the ability of the divorced spouse
to collect as a beneficiary on their ex-spouse’s death. But,
each state is different and varies their laws as to how far the
ex-spouse can reach into the estate of the deceased as a beneficiary.
Barring a contradictory provision in the divorce decree, some states
automatically cut-off the ex-spouse from collecting on all beneficiary
designations. Other states will permit a divorced spouse to collect
on non-probate assets that still list the divorced spouse as beneficiary.
If the decedent/spouse has remarried or there are children from
different marriages involved that are potential beneficiaries, it
can be a real mess. If the estate is large enough, litigation is
Naturally, there are several caveats for qualified plans, i.e.,
profit sharing plans and 401(k)s. For 401(k)s, generally federal
regulation, automatically dictate that a spouse is the primary beneficiary
without the spouse’s signature stating otherwise. Beneficiary
designations with respect to IRAs are governed by state law, and
each state has different protections for ex-spouses. Instead of
dealing with the messiness that arises from incorrectly listed designated
beneficiaries, it is much easier to make the necessary changes near
the time of the life changing event.
For other types of financial accounts, like a life insurance or
a brokerage account, typically all a person needs to update their
designations is to use the forms provided by the company managing
the account when a life changing event occurs. Many companies even
have on-line forms to update beneficiaries or will accept as adequate
a simple letter informing the institution of the changes.
So after the joy or pain of a life changing event has subsided,
take a few minutes to think about how the event will impact your
life, and review your financial and legal documents. Five minutes
of time updating the beneficiary designation on a company’s
internet website can potentially save months of anguish for your
Most people assume that
a life insurance death benefit is not taxed in any situation, confusing
income tax and the estate tax. Since life insurance death benefits
are not taxed as income, it seems to reason that benefits also escape
the clutches of the estate taxes1. This is not the case.
Generally, a beneficiary does not have to pay income taxes on a
life insurance death benefit when those payments are made in a lump
sum or regular intervals, but would pay income tax on any post-death
interest earned prior to the payment to the beneficiary. However,
as I demonstrated in (See August 2010 Newsletter), life insurance
death benefits can elevate a decedent’s estate above the estate
tax exemption level, and any amount over the exemption level would
The decisions a decedent makes prior to dying with respect to ownership
of the life insurance policy, the relationship of the beneficiaries
to the decedent and the estate planning steps taken to mitigate
the taxability of the life insurance death benefits all could impact
whether or not benefits are included in the taxable estate.
To avoid including life insurance death benefit in your estate,
two factors must be addressed. The first factor deals with making
sure the estate is not named as the beneficiary of the life insurance
death benefit. That is not as easy as it sounds. For example, a
husband and wife each set up life insurance policies only listing
the other spouse as the beneficiary and does not list any contingent
beneficiaries. The husband dies and wife receives the death benefits
from the husband’s policy. The wife continues to pay the premiums
on her life insurance policy and never updates her beneficiaries
on the policy. The wife eventually passes away and the life insurance
death benefit folds back into her estate because her beneficiary,
her husband, has already died. The wife has unknowingly increased
the size of her taxable estate by failing to update her beneficiaries.
The other factor that determines if a life insurance death benefit
is included in the estate is whether the insured demonstrates any
incidents of ownership with respect to the life insurance policy.
Examples of incidents of ownership would include:
I would hazard a guess that a majority of people maintain the ability
to change their beneficiary or to transfer their policy. Thus, most
people have "incidents of ownership" with respect to the life insurance
policy, and the death benefit would still be included in a person's
- If an individual has the right to change the beneficiary,
- If an individual can transfer ownership of the policy,
- If an individual can use the policy value as collateral for a loan, or
- If an individual has any other traditional rights of ownership.
I know you are all rushing to scan your policies
right now, if you can find them. No need; I have some good news.
First, the policy’s death benefit, along with value of the
person’s other taxable estate would need to exceed the federal
exemption for a person to pay estate taxes on any life insurance
death benefit. Right now, the federal estate tax exemption is projected
to be around $1.0 million in 2011. Maryland and D.C. also have state
estate taxes which could be applicable. Second, if your spouse,
as primary beneficiary, inherits the death benefit, the money paid
out would be protected under the unlimited marital deduction. However,
the example I gave above could come into play, if the surviving
spouse had no contingent beneficiaries listed. Further, if the insured
spouse dies after the beneficiary spouse and the proceeds are paid
to non-spouse beneficiaries, then no marital deduction will be available.
Eliminating a person’s incidents of ownership over a life
insurance policy can be accomplished in two ways. The first way
is to transfer ownership to another individual following life insurance
company and IRS guidelines. Many times that other person is a spouse
or a child of the insured. One draw back is the insured loses control
of the policy because it must be a permanent transfer, and, if a
divorce occurs, that policy is outside the control of the insured.
Also, the cash value of the insurance policy would be included in
the gross estate of the new owner of the policy and, thus, might
create estate tax issues for the new owner of the policy.
The second option is to create an irrevocable life insurance trust,
or “ILIT.” An ILIT is a specially designed trust that
acts as the owner of the life insurance policy. As an irrevocable
trust, the assets held in that trust are not part of the insured
estate for estate tax purposes. ILITs are complex tools that I will
describe in the future. If you are interested in an ILIT, given
the 2011 estate tax issues, you should talk with an attorney.
While the conventional wisdom that life insurance death benefits
are essentially income tax free is correct, make sure you have taken
the steps to ensure they are also estate tax free.
you have been reading my newsletters you will notice I attempt to
link a general theme through the articles to demonstrate practice
and theory. In this estate of the month, I demonstrate how Michael
Crichton’s delay in updating his estate plan resulted in larger
legal bills than necessary for his heirs.
Crichton, the author of novels including Jurassic Park and Disclosure,
died of throat cancer on November 4, 2008, at the age of sixty-six.
It was estimated that his annual earnings in 2008 approached $100
million mostly generated from writing novels, screenplays and television
shows. He married actress Sherri Alexander in 2005 but also had
4 ex-wives. His obituary
listed only being survived by Alexander and a daughter from a previous
marriage. But it gets very interesting from there. Alexander was
six months pregnant at the time of Crichton’s death and gave
birth to Crichton’s son several months after his death in
February. As someone in his mid-30’s who chases a three year
old around, I could not imagine chasing one in my 60’s around
but that is another issue.
Given his convoluted family relationships, Crichton did take several
steps to organize his estate to provide his heirs and charities
upon his death. He had a will, executed in 2007, and a trust in
place to manage his assets and distribute his assets to his beneficiaries.
He also had a prenuptial agreement with Alexander alleged to be
$9 million dollars over a period of 9 years that limited what she
would receive from his estate and would impact her ability to inherit
upon his death.
But, he made one crucial flaw. He did not update his will to account
for his unborn son. Most states have “pretermitted heir”
laws to protect children that are accidentally omitted, if other
children are accounted for in the will, so that they can still receive
a portion of the estate. The “pretermitted heir” law
is not a rigid, however, since an estate plan can work around the
law to “disinherit” a child. In fact, Crichton did take
steps to limit the ability of omitted children to inherit parts
of his estate in his 2007 will. Crichton did this for a precise
reason. He was rumored to be somewhat of a ladies’ man. Crichton
had a restrictive clause inserted into his will to block surprise
offspring from appearing at his death. His will stated:
"I have intentionally made no provision in this will for any of my heirs or relatives who are not herein mentioned or designated, and I hereby generally and specifically disinherit every person claiming to be or who may be determined to be my heir-at-law, except as otherwise mentioned in this will."
Words have meaning and he never did update his 2007 will. Crichton
demonstrated the intent that he did not want anyone not expressly
mentioned to inherit. Thus, by the letter of the will, his son should
not be a beneficiary. One could argue that given his daughter is
an heir, he would want to include his son. Alexander did make this
claim and contended that Crichton was in the process of updating
his estate plan to account for his son. She also petitioned a California
court to be appointed the guardian of her son and to have access
to her son’s inheritance to raise him. A very nice upgrade
for Alexander from the $9 million she was due under the pre-nuptial
contract to hundreds of millions she would have access to while
raising her infant son. Not bad.
The clause in Crichton’s will would pit his daughter against
his son for inheriting his estate. In fact, that is exactly what
happened. Alexander petitions the court to designate her as guardian
and Crichton’s son as an heir. Crichton’s daughter fought
the move. In October 2009, a Superior Court judge of California
rejected Crichton’s daughter’s argument and ruled that
her infant half-brother was entitled to a one-third of Crichton's
estate. Eventually, the estate distribution was reworked to include
Crichton’s son as beneficiary, but not without Crichton’s
estate accruing legal and professional fees from both sides of the
How does this apply to the everyday man who does not have millions
of dollars in assets? Fighting over control of estates and trusts
doesn’t just happen to the wealthy. In fact, estate litigation
is very common in second-marriage situations. By simply taking the
time to make the necessary changes to your estate plan after those
life changing events, or immediately upon notification of a life
threatening illness as in Crichton’s case, a person can save
a great deal of loved one’s time, heartache and money.
1 As most who read my newsletters know,
I am firmly in the camp that the federal estate tax is coming back
in 2011. Regardless, Maryland and D.C. apply a state estate tax
to a decedent's taxable estate.
2 It is likely that Alexander, the petitioner
in the matter, and Crichton's daughter, respondent in the matter,
used assets distributed from Crichton's estate to pay the legal
and professional fees accrued in the matter.
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