Choosing Beneficiaries for Your Retirement Accounts
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Who you name as the beneficiary of your retirement accounts and how you name each beneficiary can significantly influence your family.
As part of your retirement planning process, properly designating beneficiaries can help you contribute to your heirs' financial well-being by offering them additional alternatives for how they get the money and when those retirement assets are taxed.
Different Accounts Have Different Rules
People saving for retirement often put their money in tax-advantaged retirement plans like 401(k), 403(b), and individual retirement accounts (IRAs). While these types of retirement accounts have many similarities, there are also significant differences. One of the important distinctions concerns spousal beneficiary rights.
Spousal Beneficiary Rights
Unless they sign a disclaimer, your spouse is deemed your 401(k) plan beneficiary. This becomes more problematic if your spouse at the time of your death was not your spouse when you designated your beneficiaries—you may not think to ask them whether they are prepared to sign a waiver after you marry. State law or the IRA document determines the beneficiary rules for IRAs. Some states safeguard the right of a spouse to be a beneficiary, whereas others do not.
Assume that a husband appoints his children as beneficiaries on his IRA and 401(k) accounts after his divorce but fails to update the beneficiary on his Roth IRA (leaving it as his ex-wife). He remarries a few years later and then dies a short time later. Because she did not sign a release, his current wife receives the profits of his 401(k). His children inherit the assets in his IRA, and his ex-wife is entitled to his Roth IRA unless state law or the IRA paperwork states otherwise. Nonetheless, this may not have been his intention. A circumstance like this demonstrates why it is critical to undertake a comprehensive beneficiary review following any significant life change, such as marriage, divorce, or childbirth.
Types of Beneficiaries
The people first in line to inherit an account are your principal beneficiaries. If they are alive when the account holder dies, these beneficiaries can accept or reject the account. If the recipients opt to decline or disclaim the benefit, they cannot choose who will receive the distribution in their place.
In this case, the account is transferred to the person who would have received it if the disclaiming beneficiary had died before the account holder. If the principal beneficiary dies or declines the payout, your contingent beneficiaries will receive your retirement account.
You may also specify dependent beneficiaries, which is generally a good idea. It is typical for married couples with children to list their spouse as the primary beneficiary and their children as dependent beneficiaries. To name someone other than your spouse as the beneficiary of an ERISA-qualified retirement plan like a 401(k), your spouse must sign a waiver.
Designated beneficiary
A designated beneficiary is a person or eligible trust named on your beneficiary form. Authorized beneficiaries must exhaust the inherited retirement account before the year's end, including the tenth anniversary of the account holder's death. Some beneficiaries can wait until the tenth year to withdraw their funds, while others must take the minimum required distributions each year over the ten-year term. A beneficiary's financial professional or tax adviser can assist them in making an informed selection.
A non-designated beneficiary is an estate, a charity, or a trust. Non-designated recipients must fully distribute the inherited account by the fiscal year's conclusion, including the fifth anniversary of the account holder's death.
Eligible designated beneficiaries
Beneficiaries with special needs, chronically sick beneficiaries, the owner's minor children, spouse, and persons under age ten are all eligible designated beneficiaries with varied possibilities. A qualified designated beneficiary can determine their needed annual minimum distribution based on their life expectancy. Minor offspring of the owner may utilize their life expectancy until they reach the age of majority, at which point they must apply the ten-year rule.
Your Beneficiaries’ Options
Your beneficiaries can choose what to do with an inherited retirement account, and their decision can have significant tax consequences. As a result, you may recommend that beneficiaries consult with a legal or tax professional before making a decision.
If authorized under the plan, any recipient may choose to accept a complete distribution of the account, although there may be tax ramifications. Because distributions from conventional IRAs and qualified plans are taxable, accepting the whole amount in a single tax year may result in a significant tax penalty. Distributions from a Roth IRA that is at least five years old are generally tax-free.
Any beneficiary may re-register an IRA as an inherited one or transfer a lump sum payout from a qualified retirement account to an inherited one. This option can spread the inherited account's income tax liability over a more extended period or, in the case of tax-free Roth distributions, potentially result in more after-tax income than taking a lump sum withdrawal, depending on the type of IRA, who the beneficiary is, and what required minimum distribution rules may apply. You and your heirs should discuss the restrictions that apply to your account with your financial advisor.
Spousal Beneficiary
A spousal beneficiary can consider an inherited IRA as their own. In addition, spouses can roll over an inherited retirement account, such as a 401(k), into their own IRA. Once the transactions are completed, all usual IRA payout regulations apply. The spouse's choice to consider the decedent's IRA as their own does not have to be made right away, and the spouse may choose to re-register the account later.
Remember that an IRA rollover has advantages and drawbacks based on the investment alternatives, services, fees, withdrawal options, required minimum distributions, tax treatment, and your specific financial circumstances and retirement objectives. Your financial advisor can help determine whether a rollover is right for you.
As you can see, beneficiary decisions regarding handling an inherited retirement account have significant tax consequences. A spouse beneficiary can inherit an IRA and avoid taking required minimum distributions (RMDs) until the decedent reaches the age of 73. Before making any decisions, heirs should always speak with their legal or tax advisor.
Conclusion
The beneficiaries of your retirement assets are an essential aspect of any estate strategy. Consult your financial advisor, legal, and tax professionals about the best beneficiary alternatives for your estate planning requirements.
Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.
Portions of this article were sourced from the work of MFS Heritage Planning. Neither MFS nor any of its subsidiaries are affiliated with Optima Capital Management.
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