William Kennedy might have made a big mistake with a beneficiary designation. When the longtime DuPont employee divorced his wife, Liv, after 23 years of marriage, their divorce decree ended her claim to his pension benefits. But William never changed his beneficiary designation on his savings and investment (SIP) plan.

When he died, seven years after the divorce, DuPont paid the balance of his account-about $400,000-to his ex-wife. The estate sued, and the case wended its way through the court system, until the U.S. Supreme Court unanimously ruled his error couldn't be corrected. Documents stating a beneficiary control the outcome and can't be overruled by wills or divorces.

For financial planners, the 2009 decision underscores the importance of checking that all clients' documents name beneficiaries correctly. Smart firms review beneficiary confirmation letters or request them for their clients every year. As the Kennedy case showed, beneficiary problems can cause even the best financial plans to go awry.

BEYOND WILL-POWER

Pension plan documents aren't the only ones that rule the day when it comes to beneficiaries. That is also the case with IRAs, insurance policies and annuities, as well as some investment and savings accounts, which are all payable to a named beneficiary.

Many clients don't realize that a beneficiary designation overrides a will, says Jim Holtzman, a financial planner with Legend Financial Advisors, in Pittsburgh. "We check on their beneficiary designations every year, either by reviewing documents that are sent to our clients or requesting information from firms that do not send out beneficiary confirmation letters."

Although not every forgotten beneficiary designation will lead to a $400,000 misunderstanding and wind up before the Supreme Court, financial planners may find other problems resulting from flawed formalities. In one case, a client stipulated in a custom beneficiary designation that his spouse, the beneficiary, could disclaim her benefit in his pension and pass it along to a bypass trust in his will, says Lesley Draper, a financial advisor with Regent Atlantic Capital, a wealth management firm in Morristown, N.J.

When the client rolled the retirement plan to an IRA, the IRA custodian required that the client complete the IRA's beneficiary form. This time, he named his spouse as the primary beneficiary and his children as the backups.

However, the new form unintentionally overwrote the custom beneficiary designation from the pension plan. It wasn't until the client died years later that his advisor discovered the custom designation no longer applied to his IRA. "As far as the IRA custodian was concerned, the client had named his children as contingent beneficiaries and that was his intention," Draper says.

The IRA custodian eventually agreed to reinstate the disclaimer strategy, but only after the advisor sent the custodian's legal department correspondence proving that the deceased client intended to allow the surviving spouse to disclaim assets to the bypass trust. The advisor also had to produce the client's will and letters from the children stating that they were giving up their direct right to the assets and they understood that they would ultimately benefit from allowing the assets to flow into the trust.

The message? "Such incidents illustrate the importance of verifying what an advisor believes to be the beneficiary designation, based on what is in the advisor's records, versus what the custodian is seeing," Draper says.

SIMPLER SOLUTIONS

Naming a trust as IRA beneficiary is a common move when clients want to reduce the risk that beneficiaries will squander the money, be defrauded or withdraw funds so rapidly that tax deferral is lost. "We often suggest that clients name 'trustee under my will' as beneficiary of retirement assets, in order to provide more control over distributing the assets," says Steve Blankenship, principal of Heritage Financial Planning in Grapevine, Texas.

But too often such trusts add layers of unnecessary complexity. Heidi Davis, a financial advisor with Columbia Financial Planning in Bellevue, Wash., is working with a client to change her beneficiary from a revocable living trust to her sister. Her retirement savings are primarily in a Roth IRA. So by switching the beneficiary designation to her sister's name, her sister could draw out the funds based on her life expectancy, stretching out the tax benefits.

"There are times when keeping an entity as a beneficiary may make sense, though," Davis acknowledges. "For example, there could be a concern that the Roth IRA may end up with a brother-in-law (the sister's husband). That is not this client's goal."

One trust that was named as the beneficiary of an IRA listed six people as equal beneficiaries of the trust, called for four specific bequests to other unrelated individuals and instructed that the remaining assets be distributed outright to the other beneficiaries. As Jason Hiley, vice president of investments at Karstens Investment Counsel, in Omaha, Neb., describes the situation, when the client died, the trust beneficiaries wanted to rollover the funds into separate IRAs. The custodian instead required that the IRA be emptied within five years, accelerating tax payments.