Beneficiary Designations – A Little More Effort Now Can Make a World of Difference for your Heir

You probably have some assets that require beneficiary designations on them so you can directly name who inherits them on your death.  Some of the most common products with these designations are:

• life insurance policies;
•  work pensions;
•  RRSPs, RRIFs and TFSAs;
•  Segregated Funds; and
•  Annuities that don’t terminate when you do

If you are like 99.4% of the general population, you have either filed out the simple one page form provided by the company offering the product or have not named anyone, in which case this asset will become part of your estate on death and be distributed according to the terms of your Will if you have one or according to a set government formula if you do not.  While this might work out just fine, there is a way of increasing the chances of success and also providing a bunch of additional benefits for your heirs

Before you get too worried, in some instances, using the simple beneficiary designation form is definitely the right way to go.  For example, if you are leaving a RRSP, RRIF or TFSA to your spouse and have no children, using the simple form will allow you to avoid probate fees on your death, as well as all of the hassles, delays and risks that can go along with leaving assets to your estate.  Even better, your spouse doesn’t have to pay any tax on the money until he or she withdraws it or dies.

On the other hand, there are some potential problems that can go with using the simple form, such as:

• All heirs will receive their share of the asset on your death or at age 19, whether this is a good idea or not.  In particular, most parents seem to cringe when faced with the thought of a 19 year old child receiving a large cheque to spend any way he likes.  On a similar note, you may not like to gift directly to disabled heirs or those with addiction or money issues

• The simple forms don’t allow you to do detailed contingency planning if someone dies before you do.  For example, if you leave a $1,500,000 life insurance policy to all 3 of your children and one of them predeceases you, the 2 survivors would split the proceeds.  This might produce an unintended result if you would have preferred that deceased child’s share to go to his or her own children.  Wills and life insurance trusts easily allow for you to plan for this or other similar contingencies;

• There is no control over what happens to the money on the heir’s death.  Using the previous example, what if all 3 children survive you but one dies shortly afterwards before spending any of the money, so that each got an equal share of the $1,500,000?   If that child was married, unless his Will said otherwise, his wife might receive the $500,000 even though you would have liked it to go to the grandchildren or, if none, to your other children; and

• There can be unintended tax consequences that might penalize some of your heirs.  For example, let’s pretend that you have $1,000,000 in RRSPs to be distributed according to a beneficiary designation between those of your 3 children that survive you, plus another $2,000,000 in other assets that are distributed according to your Will between the 3 children, with a deceased child’s share passing to his own child.   In this example, the grandchildren would only be entitled to a share of the $2,000,000 but none of the RRSP.  Not only do the these orphaned grandchildren miss out on any of the RRSP money but to add to their loss, their share of the remaining $2,000,000 is further reduced because the tax on the $1,000,00 RRSPs is paid out of the $2,000,000.    As a result, their share of the estate could be reduced by almost $150,000 in taxes on the RRSPs they never actually received.

If you want to avoid these issues, you could simply leave these assets to your estate and prepare a Will that plans against these additional contingencies and controls how and when the money is distributed.  Unfortunately, leaving assets directly to the estate causes its own problems, such as

• Probate fees and additional estate costs.  In B.C., assets considered part of your estate are subject to a tax of 1.4%.  As well, your executors will be able to claim a percentage of these assets in fees;

• Delays.  Leaving assets via beneficiary designations usually means that your heirs get paid within a few weeks of your death.  Assets left to your estate are usually held until your executors have finished their job, which will take a few months at a minimum.  In some cases, if there are Will disputes, some or all of the money can be tied up for years

• Exposure to Creditors.  Although you can avoid estate creditors by using a beneficiary designation to name heirs directly, if you leave assets to the estate instead, these creditors are entitled to claim against these assets before your heirs get paid out; and

• Exposure to Will Challenges.  In B.C., if you have disgruntled children, regardless of age or circumstances, or angry spouses, they can apply to have the terms of your Will challenged.  As a result, leaving assets to your estate can mean exposing that asset to the claims of an estranged child or an embittered widow.   On the other hand,  even if you use beneficiary designations instead, you may still need to take additional estate planning steps if you have other assets of significant value that don’t have beneficiary designations, as judges are entitled to consider what assets other heirs have received outside the estate when determining what share of your estate the disgruntled heirs should receive.  For example, even if a disgruntled child might not be able to claim part of a life insurance policy left via beneficiary designations, a judge might give him a larger share of the family home after taking into account the insurance proceeds left to his siblings.

Fortunately, there is a solution that offers the best of both worlds – the detailed planning that usually goes with a Will along with the benefits of keeping assets outside of your estate: using trusts to distribute the proceeds.  In effect, you can achieve this result by replacing the simple beneficiary designation form with one prepared by a lawyer that addresses all of the ‘what ifs’ usually associated with a Will and ensuring that either;

• this document is filed with the institution holding the asset or;

•  naming the persons acting as trustees of the assets on the simple beneficiary designation form as your beneficiaries .  This second choice may be necessary for RRSPs and RRIFs, as some institutions refuse to accept the detailed trust documents.  By simply naming the trustees as beneficiaries and ensuring, in most cases, that all affected parties get the trust document confirming that the named beneficiaries are only holding the money for others, you can still accomplish your goal.

This trust document names who administers the money (the “trustee”), who is to receive it (the “beneficiaries”) and the terms and conditions on when and how the money is to be distributed.  Trustees are often other family members or even adult beneficiaries themselves, particularly when the purpose of the trust is largely focused on tax savings rather than protecting beneficiaries from themselves.   The trust document can be crafted to suit a variety of circumstances and goals.  It can also provide guidance, restrictions or authority for how the trustees are to invest or administer the trust.

When preparing the document to replace the simple beneficiary designation form, there are 2 options: including a beneficiary designation clause inside the Will and providing a notarized copy of the Will to the company, or having a separate document outside the Will.  The first option is based on legislation that allows you to create a beneficiary designation inside the Will but allows you to keep the assets you distribute using the designation outside of your estate.  This beneficiary designation clause essentially says that the assets gifted are to be kept separate from estate assets and aren’t part of your estate but that they are to distributed according to the same terms as your Will.  If this seems confusing, you are not alone!

In the end, this first option will not cost you that much to prepare, as you are often just adding a few lines to your Will and then ensuring that a copy gets filed with the relevant insurance and investment companies.  On the other hand, because it is still found in a Will, someone might still try to claim that you should still pay probate fees or claim a share under a Will challenge or as a creditor.   As well, every time you revoke your Will, you cancel the beneficiary designations inside your Will.  This means you will need to take extra steps every time you redo your Will, such as mentioning the policies in the new Will, getting a separate life insurance drafted at that time or using the company’s own simple beneficiary designation form to name the new beneficiaries.  In any of these situations, you would need to provide the company with copies of the relevant documents or the assets will flow into your estate.  As a result, for both these reasons, I recommend paying the extra cost of preparing the separate document outside the Will, especially if you are worried about creditors or Will challenges.  If you are willing to roll the dice to save money now, then I would recommend using a beneficiary designation inside a Will to replace existing simple beneficiary designations.  If nothing else, this minimizes the chances of unintended consequences and allows you to control who, how and when the proceeds are distributed.

Finally, there one huge additional benefit to using trusts for life insurance or registered products:  the potential of leaving a legal tax shelter for your heirs that can potentially pay the additional cost of preparing the trust documents a hundred times over.  In fact, many people set up trusts like this or in their Will just for the tax savings their heirs may enjoy.   Without getting into too much detail (I have articles that do this on my website for those of you looking for more), using a trust to receive an inheritance allows your heirs to report income earned by the inheritance inside the trust on a separate tax return or, if drafted appropriately, on lower income beneficiaries’ tax returns on money paid out to them.

By transferring income that would have been added to the beneficiaries’ other income to the trust’s return or to lower earning beneficiaries, there can easily thousands of dollars in savings each year.  For example, if $500,000 in inheritance from a life insurance policy earns 5% in income or $25,000 per year, the tax savings that year can be as extreme as $10,925 in some cases if there are other low-income beneficiaries.    Even if there were no other beneficiaries, the tax savings in a single year could still approach $6,000 if the high income beneficiary was able to report the $25,000 on a trust tax return rather than adding it to his other income.  As an added bonus, trusts can also help preserve other income-related government benefits like OAS pensions or the Age Credit.

In summary, while I expect this article to leave many of you scratching your heads, I suggest that you still take the time to discuss it with your lawyer or insurance / investment advisors.   Although it will cost money and time to replace your simple beneficiary designation forms, your efforts now can make a profound difference in ensuring that the right people get the right amounts at the right time after your death, with the added benefit of significant tax savings in some cases.