Choosing a beneficiary for your IRA or 401(k) can require special consideration due to tax laws. While most inherited assets are not subject to income tax, beneficiaries must pay income tax on distributions from traditional IRA and 401(k) accounts. Roth IRAs and Roth 401(k) accounts may be exempt, but only if all tax requirements are met. By taking the time to choose the right beneficiary, you can maximize benefits and avoid complications. The guide below outlines the pros and cons of each type of beneficiary to help you make the right choice.
Naming your spouse as beneficiary is often the best choice in terms of tax benefits. Your spouse can roll over the inherited 401(k) or IRA to their own plan and continue to make or delay distributions, which allows for more income tax options. In addition, if your spouse is a decade or more younger than you, designating them as your beneficiary can lower your own required distributions after retirement, which will also delay taxes and keep more assets in the account.
Income taxes aren’t the only taxes to consider when naming your spouse as beneficiary, however. Death tax may be due when your spouse dies if their taxable estate exceeds federal limits. There may also be additional tax requirements for surviving spouses without U.S. citizenship.
By federal law, your spouse must be named primary beneficiary of your 401(k) unless special documentation is submitted. Your spouse may also have legal rights to your IRA even without beneficiary status if you live in one of the community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin).
Despite these limitations, you can name a non-spouse as a beneficiary. Keep in mind that a non-spouse can roll over your IRA or 401(k) to an inherited IRA only, not their own. In addition, most non-spouse beneficiaries must empty inherited IRA or 401(k) accounts within 10 years, as required by the federal SECURE Act of 2019.
Another option is to name more than one beneficiary. If your primary beneficiary predeceases you or declines benefits, the accounts will pass on to your secondary beneficiary. You can also divide your assets among multiple beneficiaries. The designated percentages do not need to be equal and can be divided among different accounts.
A Charity or Trust
Naming a charity as your primary beneficiary shouldn’t impact your own distributions, but it can affect the ability of any other named beneficiaries to defer taxes after your death. Naming a trust can also result in complications, as special tax rules apply. In either case, seeking legal advice is recommended.
You can choose to designate your estate as beneficiary instead of an individual. Your assets can also default to your estate if any other named beneficiaries predecease you. Be aware that this may result in delayed benefits, legal fees and the loss of tax deferral options for the eventual beneficiaries of the estate.
After naming a beneficiary, make sure to keep all necessary documentation current. Your beneficiary designation forms can override other legal documents, such as wills. They should be reviewed every few years and updated if circumstances change. Always seek legal advice if you have questions.
Choosing a beneficiary for your IRA or 401(k) can require extra consideration to maximize assets and avoid extra taxes. With careful planning, you can be sure you’ve made the right choice.