Hewitt Resources

Choosing a Beneficiary for Your IRA or 401(k)

Selecting beneficiaries for retirement benefits is different from choosing beneficiaries for other
assets such as life insurance. With retirement benefits, you need to know the impact of income
tax and estate tax laws in order to select the right beneficiaries. Although taxes shouldn't be the
sole determining factor in naming your beneficiaries, ignoring the impact of taxes could lead you
to make an incorrect choice.
In addition, if you're married, beneficiary designations may affect the size of minimum required
distributions to you from your IRAs and retirement plans while you're alive.

Paying income tax on most retirement distributions
Most inherited assets such as bank accounts, stocks, and real estate pass to your beneficiaries
without income tax being due. However, that's not usually the case with 401(k) plans and IRAs.
Beneficiaries pay ordinary income tax on distributions from 401(k) plans and traditional IRAs.
With Roth IRAs and Roth 401(k)s, however, your beneficiaries can receive the benefits free
from income tax if all of the tax requirements are met. That means you need to consider the
impact of income taxes when designating beneficiaries for your 401(k) and IRA assets.
For example, if one of your children inherits $100,000 cash from you and another child receives
your 401(k) account worth $100,000, they aren't receiving the same amount. The reason is that
all distributions from the 401(k) plan will be subject to income tax at ordinary income tax rates,
while the cash isn't subject to income tax when it passes to your child upon your death.
Similarly, if one of your children inherits your taxable traditional IRA and another child receives
your income-tax-free Roth IRA, the bottom line is different for each of them.

Naming or changing beneficiaries
When you open up an IRA or begin participating in a 401(k), you are given a form to complete
in order to name your beneficiaries. Changes are made in the same way--you complete a new
beneficiary designation form. A will or trust does not override your beneficiary designation
form. However, spouses may have special rights under federal or state law.
It's a good idea to review your beneficiary designation form at least every two to three years.
Also, be sure to update your form to reflect changes in financial circumstances. Beneficiary
designations are important estate planning documents. Seek legal advice as needed.

Designating primary and secondary beneficiaries

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When it comes to beneficiary designation forms, you want to avoid gaps. If you don't have a
named beneficiary who survives you, your estate may end up as the beneficiary, which is not
always the best result.
Your primary beneficiary is your first choice to receive retirement benefits. You can name more
than one person or entity as your primary beneficiary. If your primary beneficiary doesn't survive
you or decides to decline the benefits (the tax term for this is a disclaimer), then your secondary
(or "contingent") beneficiaries receive the benefits.

Having multiple beneficiaries
You can name more than one beneficiary to share in the proceeds. You just need to specify the
percentage each beneficiary will receive (the shares do not have to be equal). You should also
state who will receive the proceeds should a beneficiary not survive you.
In some cases, you'll want to designate a different beneficiary for each account or have one
account divided into subaccounts (with a beneficiary for each subaccount). You'd do this to
allow each beneficiary to use his or her own life expectancy in calculating required distributions
after your death. This, in turn, can permit greater tax deferral (delay) and flexibility for your
beneficiaries in paying income tax on distributions.

Avoiding gaps or naming your estate as a beneficiary
There are two ways your retirement benefits could end up in your probate estate. Probate is the
court process by which assets are transferred from someone who has died to the heirs or
beneficiaries entitled to those assets.
First, you might name your estate as the beneficiary. Second, if no named beneficiary survives
you, your probate estate may end up as the beneficiary by default. If your probate estate is your
beneficiary, several problems can arise.
If your estate receives your retirement benefits, the opportunity to maximize tax deferral by
spreading out distributions may be lost. In addition, probate can mean paying attorney's and
executor's fees and delaying the distribution of benefits.

Naming your spouse as a beneficiary
When it comes to taxes, your spouse is usually the best choice for a primary beneficiary.
A spousal beneficiary has the greatest flexibility for delaying distributions that are subject to
income tax. In addition to rolling over your 401(k) or IRA to his or her IRA, a surviving spouse
can generally decide to treat your IRA as his or her own IRA. This can provide more tax and
planning options.

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If your spouse is more than 10 years younger than you, then naming your spouse can also reduce
the size of any required taxable distributions to you from retirement assets while you're alive.
This can allow more assets to stay in the retirement account longer and delay the payment of
income tax on distributions.
Although naming a surviving spouse can produce the best income tax result, that isn't necessarily
the case with death taxes. One possible downside to naming your spouse as the primary
beneficiary is that it will increase the size of your spouse's estate for death tax purposes. That's
because at your death, your spouse can inherit an unlimited amount of assets and defer federal
death tax until both of you are deceased (note: special tax rules and requirements apply for a
surviving spouse who is not a U.S. citizen). However, this may result in death tax or increased
death tax when your spouse dies.
If your spouse's taxable estate for federal tax purposes at his or her death exceeds the applicable
exclusion amount (formerly known as the unified credit), then federal death tax may be due at
his or her death. The applicable exclusion amount is $5 million in 2011.

Naming other individuals as beneficiaries
You may have some limits on choosing beneficiaries other than your spouse. No matter where
you live, federal law dictates that your surviving spouse be the primary beneficiary of your
401(k) plan benefit unless your spouse signs a timely, effective written waiver. And if you live in
one of the community property states, your spouse may have rights related to your IRA
regardless of whether he or she is named as the primary beneficiary.
Keep in mind that a nonspouse beneficiary cannot roll over your 401(k) or IRA to his or her own
IRA. However, a nonspouse beneficiary can roll over all or part of your 401(k) benefits to an
inherited IRA.
Naming a trust as a beneficiary
You must follow special tax rules when naming a trust as a beneficiary, and there may be income
tax complications. Seek legal advice before designating a trust as a beneficiary.
Naming a charity as a beneficiary
In general, naming a charity as the primary beneficiary will not affect required distributions to
you during your lifetime. However, after your death, having a charity named with other
beneficiaries on the same asset could affect the tax-deferral possibilities of the noncharitable
beneficiaries, depending on how soon after your death the charity receives its share of the
benefits.
Ishan Goraydiya is passionate writer and loves writing about Retirement and Financial Planning.
These days he is writing on Hewitt Resources.

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