4 Things to Know About Retirement Account Beneficiaries

If you've gone through the process of selecting beneficiaries in your key estate planning documents, have you made sure that your other accounts—like your IRA or 401(k)—also have completed beneficiary designation forms?

Selecting beneficiaries for retirement accounts is different from choosing beneficiaries for other assets distributed via your will, such as life insurance and personal property. With retirement accounts, you need to be aware of the impact income tax and estate tax laws may have on these beneficiaries to select the appropriate ones. Although this consideration shouldn't be the sole determining factor in naming your beneficiaries, ignoring the impact of taxes on your loved ones can lead to unintended consequences.

Here are four important things to know about retirement account beneficiaries.

1 Beneficiaries pay income tax on most retirement account distributions

Most inherited assets like bank accounts, stocks and real estate pass to your beneficiaries income tax free. However, this isn't usually the case with 401(k) plans and IRAs.

Beneficiaries will pay ordinary income tax on distributions they may receive from pretax 401(k) accounts and traditional IRAs. With Roth IRAs and Roth 401(k) accounts, however, your beneficiaries may receive those distributions income tax free if all requirements are met.

For example, if one of your children inherits $100,000 cash and another child receives your pretax 401(k) account worth $100,000, they wouldn't receive the same amount because distributions from the 401(k) plan will be subject to income tax at the child's ordinary income tax rate, while the cash is tax free.

Similarly, if one of your children inherits your traditional IRA—from which distributions are taxable—and another child receives your Roth IRA—from which distributions may be tax free—this is likely to be an inequitable inheritance. Mistakes like these can generate resentment and estrangement among heirs.

2 Name or change beneficiaries at any time

When you open an IRA or begin participating in a 401(k), you'll be asked to name beneficiaries either electronically during account setup or via a separate form. If you decide to change beneficiaries, you can do so electronically through your online account or by completing a new beneficiary designation form. However, you should consult with your account custodian or trustee before making a beneficiary change.

Naming retirement account beneficiaries is important because retirement account distributions don't follow the directions provided in your will. Due to their size, retirement accounts play an important part in estate planning, so be sure to get legal and tax advice as needed.

It's also a good idea to review your beneficiary designation forms every year when completing tax returns. Also, don't forget to update this information when there are changes to your accounts, finances or family circumstances.

3 Designate primary and secondary beneficiaries

When you're considering who to name as beneficiaries on your retirement accounts, you want to be sure there are no gaps.

Your primary beneficiary is your first choice to receive your retirement accounts. However, you can name more than one person, trust or charity as your primary beneficiary. Where a gap could occur is if your primary beneficiary doesn't survive you or decides to decline the benefits, in which case your secondary—or contingent—beneficiaries would receive the retirement benefits. If there's no contingent beneficiary named, the benefits of those retirement accounts could be lost to your estate, which could cause loss of tax benefits or other flexibility.

If you choose to name multiple beneficiaries as either your primary or contingent beneficiaries on a retirement account, be sure to specify the percent that each should receive and ensure that the total of each primary or contingent's bequest equals 100%.

Note that if your estate receives your retirement accounts, the opportunity to maximize tax deferral by spreading out distributions may be lost. In addition, it may require probate, which can mean paying attorney and executor fees and delaying the distribution of benefits.

4 Know the types of beneficiaries you can designate

You have many options when planning how your retirement accounts will transfer.

Naming your spouse as a beneficiary

From a tax planning perspective, naming your spouse as a beneficiary on your retirement accounts gives them the greatest flexibility.

For example, if your spouse is 59 1/2 or younger, they'd be able to access retirement funds without getting penalized for an early withdrawal. Your spouse could also elect to treat the retirement accounts as their own and roll the retirement plan or IRA into an IRA under their own name. This would let them use their own age to follow any rules around required minimum distributions, or RMDs.

Although the surviving spouse will still have to consider the impact of income taxes on applicable distributions, if they're older than 70 1/2 and are charitably inclined they can alleviate some of this tax burden by sending the RMD to a charity. The IRS offers a helpful list of requirements for charitable contributions.

Naming other individuals as beneficiaries

If you're married, you may have some limits on choosing individual beneficiaries other than your spouse. In certain states, federal law dictates that your surviving spouse be the primary beneficiary of your 401(k) plan benefit unless they sign a timely, effective written waiver. If you live a community property state, your spouse may have rights related to your IRA regardless of whether they're named as the primary beneficiary.

Keep in mind that a non-spouse beneficiary can't roll your 401(k) or IRA into their own IRA to treat it as their own, but they can choose to move the retirement accounts into an inherited IRA. Even so, with the SECURE Act most non-spouse beneficiaries may fall under the 10-year rule in which the inherited IRA will need to be distributed and closed by the end of the tenth year after death.

Because distributions from IRAs are taxed at the beneficiary's ordinary rate, it's important to do a tax projection for yearly RMDs to give the beneficiary some idea of the impact of the distribution on their taxes. To account for the additional tax liability, the beneficiary may want to consider having tax withheld from the distributions or plan on making quarterly estimated tax payments.

Naming a trust as a beneficiary

If you choose to name a trust as the beneficiary of your retirement accounts, there are special rules to ensure the proper path of the retirement account to your trust and avoid other income tax complications.

For example, if a trust is named as a beneficiary of an IRA and it doesn't qualify as a see-through trust under IRS rules, the IRA must be distributed under the 5-year rule and any taxes owed will be accelerated. Be sure to seek legal advice and understand all of the ramifications before designating a trust as a beneficiary.

Naming a charity as a beneficiary

If you don't have a spouse, other individual beneficiaries or trusts you'd like to name as primary or contingent beneficiaries on your retirement accounts, you can choose a charity whose mission you support.

By naming a charity, the organization wouldn't receive any of the tax-deferral benefits that individuals or possibly a trust would receive, but they'd receive the immediate benefit of using the funds from your retirement accounts to further the philanthropic missions you care about. Additionally, the charity can withdraw assets from the retirement account income tax free because charities are tax-exempt entities.

The bottom line

When developing and reviewing your estate plan, it's important to ensure you've thought of how all assets and accounts—including your retirement accounts—will be distributed. By speaking openly with your financial, tax and legal professionals about your estate planning goals, you can feel secure that your designated beneficiaries will benefit in the way you intend.

To start the conversation about your financial estate plan, get in touch with a First Citizens Wealth Consultant.