Be Careful with IRA/401k Beneficiaries

In this article, I talk about IRA and 401k beneficiaries. IRA and 401k accounts are great ways to save for regular or roving retirement. Most folks focus on contributing and investing in these retirement savings vehicles, but if your beneficiary declarations are not right, your heirs may be stuck with a big tax bill.

Disclaimer

I am not a financial professional. Please consult one before taking any action on the ideas presented below.

“’Tis impossible to be sure of any thing but Death and Taxes” – Christopher Bullock, 1716

Having ample funds for retirement can make for a fun and mostly worry-free Chapter 2. Most people try to save enough money for a long retirement. As a result, people often pass away with undistributed money left in their IRAs or 401ks. The remaining funds are distributed to people listed as account beneficiaries. Beneficiary designations can have a big impact on how much of the inheritance finally makes it to your heirs.

Primary Beneficiaries

Primary beneficiaries are the people who will inherit your account when you pass. You can have any number of primary beneficiaries and you can typically set a percentage of your account for each beneficiary. For married couples, it is customary to name your spouse as your sole primary beneficiary. It is common to specify children or other close relatives as primary beneficiaries if you are single.

If your estate is very large, you may choose to designate a non-spouse as a primary beneficiary. Should your spouse’s net worth be close to the Estate Tax exclusion limit, you might want to have someone other than your spouse as the beneficiary. We should all have such worries 🙂

Secondary Beneficiaries

If none of the primary beneficiaries are living, the next folks in line to inherit are often listed as secondary beneficiaries. Again, you can specify inheritance percentages for each, perhaps influenced by how much support you previously provided to them. Careful consideration is advised for any inheritance so that peoples’ feelings are not hurt. Many retirement professionals encourage sharing your plans with loved ones so they are not surprised while still grieving your loss.

Per Stirpes Allocation

Another recent nuance for account beneficiaries is the concept of per stirpes allocation. In case not all beneficiaries are living when you pass, a per stirpes allocation indicates the inheritance will be split evenly at every level of succession.

For example, my friend Joe is single and had three children, Larry, Darryl, and Darryl.

Each of them had two kids named George, but Larry has since passed away. If Joe passes today, each Darryl would get one third while Larry’s sons would split his one third equally. Some people find this an equitable way to pass down funds to their heirs.

The Taxman Cometh

Standard inherited accounts have their basis adjusted when they are inherited. However, the basis for retirement account assets (for IRAs and 401ks) are not adjusted. When someone inherits such an account, s/he has 10 years to withdraw the funds. The withdrawal period allows for continued tax-advantaged growth and the ability to withdraw funds that limits their tax liability. The goal for the beneficiary is to manage the IRA/401k money along with their other taxable income to limit the tax liability.

The Trust Trap

Many people I know have created trusts to hold their assets so their survivors could avoid probate court. Probate court exposes one’s personal finances to the public and can delay the resolution and distribution of funds, so it is understandable why trusts are popular.

Despite their popularity, a trust should not be listed as a beneficiary of a retirement account. I recently learned of several friends whose parents had done just that, so I feel it is important to stress this point.

Making a trust the beneficiary of an IRA/401k is a problem because trusts are not people. As such, the IRS doesn’t allow trusts to delay withdrawing funds. This forces all trust beneficiaries to recognize all of the inherited income in one year. Taking such distributions could push them into a higher tax bracket and remove the possibility of an additional decade of tax-advantaged growth. Bad. Very Bad.

Bringing It All Together

So, what might a common beneficiary list look like? I’d say having your spouse as a primary beneficiary (not your trust) and having per stirpes for secondary beneficiaries is a good place to start. Adjusting for large estates or addressing needful heirs would be considered from there.

If you have no direct heirs, perhaps applying such an approach to close family members or a helpful blogger might please you. 🙂

How are you approaching inheritance?