Who do you want to get the money? And who do you want to get the money if your beneficiary dies before all of the plan assets have been distributed?
As is frequently the case, the decision is not as easy as it may first appear. Retirement plan assets require special attention because they pass outside of a person’s will. Updating your will does not affect named beneficiaries, and a lack of planning in this area can defeat the purpose of a well-thought-out estate plan.
Perhaps the least complicated thing to understand with regard to beneficiaries is the importance of revisiting your choice on a regular basis―particularly after major life events, such as birth, marriage or remarriage, death, or divorce. You wouldn’t be the first person to unwittingly bequeath assets to an ex-spouse or another person no longer present in your life.
The rest is a bit more complicated. The choice of beneficiary and contingent beneficiary for your retirement plan assets―a spouse, family member, friend, or even a trust or charity―can have major consequences. It factors into the taxability of your estate, as well as the income taxes and the taxable estate of your beneficiary.
Nevertheless, there are basic financial and tax considerations that you should understand when making your choice of beneficiary for a 401(k), IRA, or other qualified retirement plan.
Most contributions that you or your employer make to a retirement plan are not subject to federal income tax. Since you do not pay tax on the contributed funds, the withdrawals (or distributions) from your plan are subject to tax.
There is an exception for plans where the contributions are not tax-deductible―for example, a Roth IRA. Because you already paid tax on the money you contributed to the Roth IRA, and the income accumulates tax-free, the distributions are not taxable.
Typically, your beneficiary will be subject to federal income tax on withdrawals from the retirement plan to the same extent as you would have been. He or she must begin to withdraw funds (referred to as required minimum distributions) from the inherited retirement plan shortly after your death, thus incurring income tax consequences.
Under most circumstances, the value of your retirement plan assets is included in your estate for estate tax purposes. Subsequently, the inherited assets become part of your beneficiary’s estate.
As with most things tax-related, there are a number of exceptions to these general rules, as described below. The exceptions may influence your choice of beneficiary.
[Simply for purposes of illustration, and since women typically outlive men, we have assumed that you are a man and that your spouse and beneficiaries are women. The tax laws are gender-neutral.]
Spouse as Beneficiary
If you leave your retirement plan assets to your spouse, she (as a surviving spouse) is entitled to special treatment under federal income and estate tax laws.
Income Tax Considerations
Your surviving spouse has the option to treat your IRA as her own. That means she isn’t required to withdraw funds and pay taxes on those funds until she reaches age 70½. (There are special rules if you die before you reach age 70½.) To qualify, your spouse must have an unlimited right to withdraw funds from your IRA and must be the sole beneficiary.
As opposed to treating your IRA as her own, your spouse can choose to roll over the IRA (or other qualified retirement plan) into her own traditional IRA. This approach also delays the withdrawal requirements and related income tax consequences. If your spouse chooses this approach, she must complete the roll-over within 60 days of the date of your death.
As a third choice, your spouse can choose to be treated as a beneficiary, rather than owner, of your IRA. If she chooses this option, she cannot make additional contributions to the IRA and must begin withdrawing funds―and paying any resulting income taxes―shortly after your death. The exact amounts of the required withdrawals are calculated based on the rules applicable to nonspouse beneficiaries, as explained below.
Estate Tax Considerations
If you name your spouse as beneficiary, and she is a U.S. citizen, you’ll reduce the size of your estate for federal estate tax purposes. Under the marital deduction rules, the amounts you transfer to your spouse―but not to other individuals―are deducted in calculating your taxable estate.
The bequeathed assets will, subsequently, increase your spouse’s estate.
Nonspouse Person as Beneficiary
Under the law, a spouse is entitled to certain retirement assets. If you are married and plan to designate a beneficiary other than your spouse, you will most likely need her consent to do so.
You should also know that, in this context, a nonspouse beneficiary generally receives less favorable treatment under federal tax laws than does a spouse.
Income Tax Considerations
Your nonspouse beneficiary can roll over distributions from your IRA or qualified plan directly into an IRA that she establishes specifically for this purpose. (It is important to note that qualified plans are not required to offer beneficiaries this option.)
The IRA that results from such a rollover is considered an inherited IRA for tax purposes. In other words, your beneficiary will not owe tax on the assets until she withdraws funds from the IRA. Her required withdrawals must, however, typically begin in the year after your death.
Generally, longer mandatory withdrawal periods, with smaller required withdrawals each year, are more advantageous from an income tax perspective. The actual amount your beneficiary is required to withdraw depends on whether you die before or after your required beginning date for mandatory withdrawals―and is significant because of the income tax implications for your beneficiary.
If you die on or after this date, the required withdrawal amount is calculated based on the longer of your life expectancy or your beneficiary’s life expectancy.
If you die before this date, the calculation is based on a five-year rule unless your beneficiary specifically elects to extend the withdrawal period based on her life expectancy. Under the five-year rule, all the assets must be distributed by the end of the fifth year after your death. If the assets in your retirement plan are sizeable, the five-year rule can significantly reduce the after-tax value of the assets to your beneficiary by subjecting them to tax earlier (and at a higher dollar value per year) than would otherwise be the case.
There is one more exception to the normal required withdrawal calculation: If your beneficiary is more than ten years younger than you are, she is considered to be only ten years younger in determining life expectancy. If your beneficiary is a young grandchild, for example, this rule limits the period of time over which distributions can be made and potentially increases the tax impact.
Estate Tax Considerations
If you name a person other than your spouse as beneficiary, your retirement plan assets will be included in your estate for federal estate tax purposes. Only transfers to a spouse―not to other individuals―are deducted in calculating your taxable estate.
The assets you transfer will, in turn, increase your beneficiary’s estate. Unlike most other inherited assets, retirement plan assets do not receive a step-up in basis for federal tax purposes.
Trust, Estates, or Charities as Beneficiaries
In choosing your beneficiary, you aren’t limited to individuals. You can name a trust, an estate, or a charity as a beneficiary.
There can be significant income tax and estate tax benefits that result from naming an entity rather than a person as beneficiary―particularly if the entity is a charitable organization. There are also many pirtfalls to watch out for. Because of the complexities involved, it’s important to consult with your advisor at Bader Martin before selecting any entity as your beneficiary.
Within nine months of the date of your death, your beneficiary can choose to disclaim―i.e., irrevocably refuse, in writing and with no qualifications―a portion or all of the assets she is to inherit. Under such circumstances, the disclaimed assets pass to a successor beneficiary, either a named contingent beneficiary or, if none exists, a beneficiary determined under the plan document and federal law.
Often, such a disclaimer is motivated by tax considerations. The original beneficiary will never receive the disclaimed assets and, as a result, will not owe income or estate taxes on them.
Coordination with Estate Plan
Because of the potentially significant income and estate tax implications, it is important to integrate your choice of beneficiary with the detailed provisions of your will and overall estate plan. A beneficiary designation that runs counter to the tax and financial strategies employed in creating your estate plan can have a devastating tax cost.