Beneficiary designations: why they matter

A beneficiary designation is the instruction on file with a retirement plan, IRA custodian or insurer that says who receives the account when the owner dies. It is usually a short form filled out when the account is opened and then forgotten. That is the reason it deserves attention: for many households the form, not the will, decides where the largest financial asset goes.

How a designation works

The IRS describes a beneficiary as generally any person or entity the account owner chooses to receive the benefits of a retirement account or IRA after death, named under the procedures the plan sets. The key phrase is "under the procedures the plan sets." The account is a contract between the owner and the plan or custodian, and the institution pays whoever is named on its records.

Most forms ask for two levels:

• Primary beneficiaries receive the account first. If there is more than one, the form assigns each a percentage.
• Contingent beneficiaries (sometimes called secondary) receive the account only if no primary beneficiary is living when the owner dies.

Some forms also ask what happens to a share if a beneficiary dies before the owner, for example whether it passes to that person's children or is divided among the remaining beneficiaries. The wording and defaults differ from one institution to the next, so the form itself is the place to check.

Why the form usually outranks the will

Assets with a named beneficiary generally pass directly to that person. They do not go through the will or through probate, the court process for settling an estate. A will that says "everything to my children" generally does not redirect a 401(k) whose form still names someone else.

The same idea applies to other accounts that pass by their own terms. The Consumer Financial Protection Bureau notes that most joint bank accounts are held with "rights of survivorship," meaning the money passes to the surviving owner when one owner dies. Life insurance and many annuities work through beneficiary forms as well.

This is the most common misunderstanding in the area. Updating a will does not update a beneficiary form, and the two can end up pointing in different directions.

Spouses and workplace plans

Federal law gives spouses particular protection in employer plans. Pension-type plans generally must offer a married participant a survivor annuity for the spouse unless both the participant and the spouse consent in writing to something else. Many defined contribution plans, the category that includes 401(k) plans, avoid the annuity requirement by providing that the death benefit is paid in full to the surviving spouse unless the spouse has consented to another beneficiary. The IRS notes that plans must require the spouse's consent to be witnessed by a plan representative or a notary.

In practice this means a married person who wants a 401(k) to go to a child, a sibling or a trust generally needs the spouse's written consent on the plan's own form. It also means someone who marries after naming a beneficiary may find that the earlier choice no longer controls. The IRS suggests that a participant who marries notify the plan administrator.

IRAs are not covered by these federal plan rules. Whether a spouse has rights in an IRA depends on state law and the custodian's agreement, and those vary.

When no one is named

If the form is blank, or everyone named has already died, the plan document or custodial agreement supplies a default. Defaults differ. Some pay a surviving spouse first, others pay the owner's estate.

Landing in the estate has two consequences. The account becomes part of probate, and the tax rules change. Withdrawal timelines for inherited accounts depend on who the beneficiary is, and an estate is treated as a beneficiary that is not an individual, which can mean a shorter payout period than an individual would have had. The post on inherited IRAs explains those timelines.

Events that make a form out of date

A form reflects the day it was signed. Some people review theirs after:

• Marriage or remarriage. Spousal rights in workplace plans may change who receives the account.
• Divorce. A divorce decree does not necessarily remove a former spouse from a form. The IRS advises a divorced participant who wants to change a beneficiary to contact the plan administrator and follow the plan's procedures. A court order dividing a plan can also give a former spouse rights; see divorce and retirement accounts.
• A birth, adoption or death. A form that names "my two children" by name leaves out a third.
• A job change or rollover. A new account starts with a new, empty form. The designation on the old account does not travel with the money.

Questions worth asking

A few points come up often when people look at their forms:

• Does every account have both a primary and a contingent beneficiary on file, and does the institution's record match what the owner remembers?
• If a minor child is named, who would manage the money? A minor generally cannot take control of an account directly, and the arrangements for that are set by state law.
• If a trust is named, does the trust still exist, and was it drafted with retirement accounts in mind? Trusts as beneficiaries follow their own set of IRS rules.
• Do the forms and the will tell the same story?

Because these rules depend partly on state law and on each plan's documents, an estate planning attorney or tax professional can advise on how they apply to a specific family.

When a plan participant dies, the IRS notes that the survivor generally starts by contacting the employer or plan administrator, who will explain the forms of payment available. The post on steps after the death of a spouse covers that process.