Naming IRA and 401K Beneficiaries

You want your assets to go where you direct them - but making simple mistakes in setting up your IRA or 401K can keep this from happening.

Tax-Deferred Advantages

When a beneficiary receives an inherited IRA or 401K, they can usually roll it into a special IRA account and continue to receive the tax deferral, allowing the money to continue to grow tax free.

Spouse as Beneficiary

This is the most common designation, and rightfully so. If fact if you are married and don’t name your spouse as primary beneficiary many plans require a signed consent form from your spouse. Spousal inheritance of an IRA allows for the spouse to roll over the assets into their normal IRA plan. This special case allows the distribution of the funds to follow the normal rules for IRAs, where a non-spousal inheritance requires distributions to start when the deceased plan would have required. If you select your spouse as beneficiary, remember:

Minor Children as Beneficiary

A minor cannot hold assets in his or her name, so if a minor receives the proceeds from an IRA or 401K the state names a financial institution as guardian of the estate proceeds. This incurs fees, and results in 100% of the assets transferred to the minor when he or she becomes 18. Naming a trust as beneficiary solves this problem, as management of the assets are already detailed and no court appointment is necessary. It also allows you to time the release of assets to the beneficiary as they age, with disbursements spread over years or at set milestones. This approach does have tax implications, since the IRA or 401K tax benefits cease when transferred to a trust, triggering income taxes. If the value of the IRA or 401K is less than $50,000 then the tax impact can be minimal. For assets with higher value alternatives should be considered, such as setting up an irrevocable trust estate, sometimes called a Minor’s IRA Trust that starts at the original grantor’s death and allows the minor’s expenses to be paid from the trust with low tax rates based on the smaller income. Sounds complicated? Here is a simple answer: if you have an IRA or 401K that will likely exceed $50,000 and you want to name a minor as beneficiary or contingent beneficiary you should seek professional advice.

Leaving the beneficiary unnamed

If you fail to name a beneficiary, the assets are passed to the estate. This raises the value of the estate, possibly triggering probate and estate taxes. It also removes the option of rolling the inherited IRA or 401K into a new inherited IRA preserving the special tax status. Only by transferring the assets directly via the beneficiary does the tax benefit remain intact.

Naming a Trust as Beneficiary

Qualified trusts can be named as beneficiaries of IRAs and 401K plans because of new tax codes put into effect in late 2007. To qualify the trust must be irrevocable after the grantor’s death, be valid in the state, name individuals as trustees and as beneficiaries and be provided to the plan administrator before October 30 of the year following the date of death. Using this qualified trust (sometimes called a look through or see through trust) retains the tax deferred status of the investments and allows the normal distribution rules to apply.

Inherited IRA Minimum Required Withdrawals

As you age, the government requires you to start taking distribution of your IRA and 401K assets based on your life expectancy. Currently this requirement starts the year you reach 70.5 years old. This required distribution is not waived if the asset is inherited: the person inheriting the IRA or 401K is required to start taking minimum distributions the year the original owner would have been required to do so. But since the new owner’s life expectancy is used in the calculations the required distributions can be much smaller per year. Distribution can be yearly or monthly, whatever works best for you. Some advisors recommend taking a single distribution near the end of the year (say, December 15) to allow the tax deferred earnings to be as large as possible. But don’t cut it close, if there are any issues with paperwork or computer malfunctions that hold the distribution into the new year you might have to pay serious penalties.

There is a 5 year standard distribution for inherited IRAs. If the recipient does not start taking distributions within the year following the date of death, the entire amount must be distributed over 5 years, dramatically reducing value of the tax deferral.