That boring beneficiary paperwork could cut the tax bills
In the 15 years retired Judge Frank Lucchino served in Allegheny County Orphans’ Court, he saw a lot of families paying taxes on inherited money they could have avoided if they had just done one simple thing: update the beneficiary on life insurance policies.
Pennsylvania’s inheritance tax law contains a loophole that cancels taxation on life insurance money paid to named beneficiaries.
That and other quirks of state and federal law make the simple task of filling out — and keeping updated — your beneficiary list important across a number of legal documents. Just do it, experts who deal with such issues say.
Judge Lucchino knows from his experience handling inheritance and estate conflicts from the bench that people aren’t familiar with all the ins and outs of the laws that apply.
Under Pennsylvania’s tax loophole, for example, as long as a relative or nonrelative is named as a beneficiary on a life insurance policy, that person isn’t subject to the normal inheritance tax of 4% for relatives or 15% for nonrelatives.
Instead, the judge said, he often saw instances such as this: A husband who would name his wife as the beneficiary, but the wife died before him, and the husband had failed to add the children as beneficiaries.
“You pay the premium all your life for a life insurance policy, and if you don’t name your children or anyone else specifically as a beneficiary, they end up paying tax on money they could have gotten taxfree,” said Judge Lucchino, who retired in 2016.
The consequences of not keeping an eye on who is named beneficiary could be far more devastating than an unnecessary tax bill. In several well-documented cases in Allegheny County and across the state, the ex-spouse of a person who died wound up being entitled to collect money that should have gone to the current spouse or someone else.
Many people think an updated will is all they need to carry out their wishes after death. That is typically true with Pennsylvania law.
But in cases involving federal law, the beneficiary designation on life insurance policies and investment accounts will outweigh all other legal documents.
Failing to update a simple form has brought heartache to many families, said Lynnette KhalfaniCox, founder of the Houston-based website AskTheMoneyCoach.com.
“This causes a whole host of issues, ranging from family fights over assets to ex-spouses being awarded inheritances solely
because the deceased forgot to change crucial paperwork,” she said.
It can get messy
Pittsburgh attorney Timothy Giltinan handles one or two estates cases every year that run into issues due to a client failing to update beneficiary designations on life insurance.
Sometimes, there’s an easy solution.
The parent may have named three children as beneficiaries, but not all of the children survive the parent. The surviving children would simply share the insurance money with their deceased siblings’ children or grandchildren.
Other times, the situation can be so messy it has to get fixed in court.
“Parents will name their minor child as the beneficiary, and the parent passes while the child is still a minor,” said Mr. Giltinan, a sole practitioner with a family-owned law firm Downtown. “At that point, you have to go to court to appoint a guardian for the child to handle the proceeds.”
His most recent case dealing with a beneficiary conflict involves the death of a spouse who was in the middle of a divorce. The couple had not updated the beneficiary form on a retirement account.
The Pennsylvania legislature passed a law in 1992 to protect the forgetful spouse who failed to take that one crucial step after the divorce. The law assumes divorced spouses usually don’t want to benefit their former spouses, so it treats an ex-spouse as though they are already deceased if a beneficiary dispute comes up.
That means if an exspouse is listed as the beneficiary on any insurance policy, annuity contract, pension or profit-sharing plan, that person is considered to be already dead and is therefore skipped over in favor of a contingent beneficiary, or the money would go to the estate of the decedent.
However, federal law has the upper hand.
If the asset is held in an employer-sponsored plan such as a 401(k) retirement account or a workplace life insurance policy that falls under the federal Employee Retirement Income Security Act (ERISA), state law doesn’t apply.
If a divorced person were to die and their ex-spouse is still named as the beneficiary of their workplace 401(k) plan, the funds are payable to the ex-spouse.
“I always send out a letter to my clients after a divorce decree is entered, reminding them to redesignate the beneficiary on any asset they own,” said Lea Anderson, a partner at GRB Law, Downtown, and former chair of the family law section of the Allegheny County Bar Association.
Invariably, many still forget. Sometimes, the oversight isn’t discovered until years later when the client comes back to get a will drafted, which prompts them to take another look at their beneficiaries.
Going through a major event? Better review
Other life changes such as marriages or death of a loved one are occasions to review beneficiaries, said Ken Nuss, CEO of Annuity Advantage, an online annuity marketplace based in Medford, Oregon. “There may be new people in your life that you want to include — such as grandchildren,” he said.
Before making changes, it’s important to understand how primary and contingent beneficiaries work. A spouse would usually make the other spouse their primary beneficiary, and children would be contingent beneficiaries. Contingent beneficiaries receive the proceeds if the primary beneficiary dies before the policy owner.
“Suppose you’re married and have three adult children,” Mr. Nuss said. “The default is to name your spouse your primary beneficiary and name your children contingent beneficiaries who will all share equally in the proceeds.
“Here’s where it gets complicated,” he said. “Suppose Child A has three children, Child B has none and Child C has two, for a total of five grandchildren.
“What happens if both your spouse and Child C predecease you? In that case, unless you’ve set up your beneficiaries correctly, all proceeds would go to your surviving children. Child C’s two children would be disinherited,” he said. “That’s not what most people want.”
He said individuals can specify that if one of their children is deceased, their share will go to his or her children. This is called per stirpes distribution, which means each branch of the family receives an equal share.
Changing a beneficiary designation usually just requires filling out a form, which can often be done online.
Ms. Khalfani-Cox said one way to avoid letting it go unnoticed is to mark a date on the calendar for an annual financial paperwork checkup and schedule it as a recurring event.
“Anytime you have a major life event — marriage, divorce, the birth of a child or grandchild or the death of a loved one — ask yourself: Am I — or was I — financially connected to this person?” she said.
“If the answer is yes, then that’s a reminder that you need to review your financial ties to that individual and adjust accordingly, including perhaps changing a beneficiary designation.”