How Outdated Beneficiary Designations and Property Titling Affect Income Taxes and Other Unintended Consequences

When it comes to estate planning, many people focus on creating wills or trusts to ensure their wishes are carried out according to plan. However, an equally important yet often overlooked aspect is managing the income tax implications tied to your estate plan.

Periodic reviews of beneficiary designations, asset titling, and estate planning documents are crucial for ensuring your wishes are still being carried out while also minimizing the tax burden for your heirs.

Why Beneficiary Designations Matter

Beneficiary designations are used for assets such as retirement accounts (e.g., 401(k)s, IRAs), life insurance policies, annuities, and payable-on-death bank accounts. These designations determine who will receive assets upon your passing, regardless of what your will or trust may say. Over time, life changes such as marriage, divorce, the birth of children, or the death of a beneficiary, can make old beneficiary designations outdated or incorrect.

The Importance of Property Titling

Similarly, the way property is titled (e.g., homes, bank accounts, vehicles) dictates how ownership transfers after death. For example, joint tenancy with rights of survivorship ensures property automatically passes to the surviving owner. While sole ownership or tenancy in common requires assets to pass through probate as directed by your will or trust.

Also, if you own a non-retirement account asset by yourself, its basis will be adjusted to the current market value when you pass away. This is called a full step-up in basis. However, if you own the asset jointly with someone else, only half of its basis will be adjusted. This step-up is important because it allows a business asset to be depreciated again or an investment asset to be sold with little or no gain, reducing the tax burden.

Real-Life Downfalls of Neglecting Reviews

#1 Outdated Beneficiaries After Divorce

John divorced his first wife, Mary, ten years ago and remarried Lisa. However, John never updated the beneficiary designation on his 401(k), which still names Mary as the beneficiary. When John passes away unexpectedly, his ex-wife receives the retirement funds, leaving Lisa with nothing.

Even though John’s will direct that everything is to be left to Lisa, the 401(k)-beneficiary designation overrides the will. In addition, Mary does not enjoy the opportunity for spousal rollover benefits that could have reduced her taxes and extended payouts.

#2 The Birth of a Child Overlooked

Sarah and Mark welcome their first child, Emma, but never update their life insurance policies. Sarah’s policy still reflects her pre-marriage beneficiaries, which are her siblings. When Sarah tragically passes away, her siblings inherit the life insurance proceeds instead of her husband and daughter. Leaving Mark unassisted with the financial duties of raising Emma.

#3 Sole Ownership Versus Joint Ownership

Jane owns a vacation home titled solely in her name, despite sharing it with her husband, Michael. The home is valued at $300,000 at the time of her passing. Although the home needs to go through probate to pass to her husband, Michael receives a full step-up in basis. When he sells the property for $300,000 shortly after Jane’s passing, he pays no capital gains tax.

Let’s say Jane and Michael own the vacation home jointly, with an original purchase price of $100,000. Upon Jane’s passing, the property transfers to Michael without going through probate. Michael receives a step-up in basis on Jane’s half interest only, resulting in a new basis on the vacation home of $200,000 ($150,000 for Jane’s step up, plus $50,000 of Michael’s original cost basis). This will result in a $100,000 taxable gain when Michael sells for $300,000 after Jane’s passing.

Final Thoughts

By making a review of your beneficiary designations and property titles a regular part of your financial checklist, you can protect your estate plan, minimize legal and tax complications, and provide peace of mind for yourself and your loved ones.

Your KT Estate Planning team is here to help with any estate and income tax questions you may have!