Choosing a Beneficiary for Your IRA or 401(k)

Establishing or participating in a retirement plan is an important part of your financial future. If you currently have a retirement plan, understanding all of your options when it comes to naming a beneficiary is an important part of your planning.

Selecting beneficiaries for retirement benefits is different from choosing beneficiaries for other assets such as life insurance because with retirement benefits, you need to be aware of 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.

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 traditional 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 traditional 401(k) account worth $100,000, they aren't receiving the same amount. The reason is that all distributions from the traditional 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. Keep in mind, if your intention is to give the same amount to each child in the examples above, you can increase the amount given to one child to compensate for the taxes.

When you establish an IRA or 401(k), you complete a form 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.

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 may not always be the best result.

Your primary beneficiary is your first choice to receive retirement benefits. 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.

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, but the total must equal 100%). 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). The advantage of this is 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.

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 and executor fees and delaying the distribution of benefits.

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 decide to treat your IRA as his or her own IRA. This can provide more tax and planning options.

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 estate 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 estate tax purposes. That's because at your death, your spouse can inherit an unlimited amount of assets and defer federal estate 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 estate tax or increased estate 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 estate tax may be due at his or her death. The applicable exclusion amount is $11.7 million in 2021.

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 non-spouse beneficiary may be able to roll over all or part of your 401(k) benefits to an inherited IRA.

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.

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.

Equitable Retirement Plan Specialists

The ADA endorses retirement savings and distribution plan products through Equitable Financial that can assist you toward achieving your retirement goals. With more than 50 years of experience working with ADA members, Equitable Retirement Program Specialists are licensed to provide the expertise and resources to assist you and your dental team evaluate the plan options best suited for your personal retirement goals. In addition, Equitable provides a full range of recordkeeping and plan administration services to complement its suite of retirement product offerings for ADA members and employees. New for 2021 are expanded financial planning services provided by Equitable Advisors financial professionals upon request. For additional information on these ADA-endorsed member benefits, please call Equitable at 1-800-523-1125 or visit https://equitable.com/associations/ada.