Nuts & Bolts
The beneficiary designation form is the key component impacting the inheritance of your 401(k) savings. The beneficiary form dictates to whom the money in the plan goes.
Note that a will or trust does not supersede your beneficiary designation form.
You likely filled out this form when you first signed up for the retirement plan. You may also make changes to your beneficiary information via the same designation form. This document should be revisited periodically and reviewed after any life changes.
Also, by law, your spouse is automatically the beneficiary of your 401(k). (You should still name your spouse on the official form.)
If you wish to name someone besides your spouse, he/she needs to sign a waiver. If your spouse does so, then you may designate anyone to inherit the funds.
What key things should I think about?
When deciding who should inherit your 401(k), consider the (1) income and estate tax implications for the beneficiary and the (2) flexibility of/access to the funds that that person is granted.
Who? <Avoid the gap>
It is vital that you name a primary beneficiary, typically your spouse, as well as additional beneficiaries as alternates. You may also name multiple primary beneficiaries.
The goal is to avoid gaps with your designation forms because the plan administrator will not automatically pass the assets to your heirs if they are not specifically named. Rather, the plan assets would move into your estate, a less desirable outcome.
If the plan assets go to your estate, they may be subject to additional, less favorable, distribution rules. The probate court process may also result in lawyer and executor fees and delaying the distribution of benefits.
Distributions <Access to the money>
Your beneficiary’s age matters when he/she inherits your 401(k) savings, as most retirement accounts require annual minimum withdrawals at a specified age.
The distributions may be calculated based on the original saver’s age at time of death OR the heir’s current age.
IRS rules on required distribution amounts vary, depending on the type of beneficiary and the retirement vehicle. The plan sponsor may also restrict the options available to your beneficiary.
The funds can be paid out in several ways, including a lump sum, over five years, or possibly extended over the beneficiary’s life expectancy. Note that the options for spouses versus other beneficiaries will likely diverge.
Remember that the distribution amount from an inherited traditional 401(k) will be taxed when the funds are paid out to you. Therefore, the inflow will potentially increase your marginal tax rate. Please consult a tax professional as needed.
Those who inherit a traditional 401(k) plan will likely be affected by income tax, both federal and state. This is due to the tax-deferred benefit, on contributions and earnings, accrued by saving through a 401(k) plan.
These tax implications underscore the value of considering your beneficiary’s tax bracket and age. For instance, perhaps an heir with a lower income, and thus a lower tax bracket, would greatly benefit from inheriting your retirement account. Also, younger heirs would benefit more from an extended distribution period.
When mulling whom the beneficiary of your retirement savings should be, think about that person’s age and income tax bracket. These factors directly impact the inheritor’s access to the money and potential tax liability.