U.S. workers have stashed $6.9 trillion in their 401(k) plans as of Sept. 30, 2023, according to the Investment Company Institute, an association representing regulated investment funds.
A healthy chunk of those 401(k) assets is being steered toward spouse and non-spouse beneficiaries who take over the plans after the original account holder passes away.
All beneficiaries should understand the rules surrounding inherited 401(k) plans, which requires some homework.
“Naming a beneficiary to a 401(k) allows the plan participant to designate who will receive the plan balance at death. Having a plan recipient means the account avoids the probate administration process,” says David T. DuFault, an attorney at Sodoma Law in Charlotte, North Carolina. “As long as the named beneficiary survives the plan participant, he or she will receive the plan balance.”
Failure to name a beneficiary will most likely lead to the account balance being distributed to the plan participant’s estate, which has numerous disadvantages. “Those drawbacks include exposing the account to probate and estate creditors, increased costs and likely a shortened withdrawal period,” DuFault says.
How can 401(k) beneficiaries and the original plan account holder get the transfer process right? Retirement planning experts suggest following these guidelines.
— Designate a beneficiary.
— Think carefully when choosing a beneficiary.
— Update beneficiaries after major life events.
— Understand 401(k) and IRA plan differences.
— Talk to your beneficiary.
— Understand tax implications for beneficiaries.
Designate a Beneficiary
The process of designating a beneficiary for a 401(k) typically occurs when the original plan holder first enrolls.
“Upon enrolling in your 401(k) plan with your employer, you will be asked to name your beneficiary or beneficiaries,” says Theresa Becker, a certified financial planner at Rockland Trust in Boston. “If the plan holder doesn’t complete that task and passes away, plan assets distribution is determined by the default beneficiaries set out in the employer’s retirement plan document.”
Default beneficiary designations may include these:
— If the owner is married, the default beneficiary is the spouse.
— If the spouse is deceased, the assets are split equally between the remaining family children.
— If no children remain, then the 401(k) plan assets go to the estate.
“Even if this default process is followed, the plan beneficiary generally will not be able to take ownership until after the probate process,” Becker says. “If there is a major life event, the owner’s online plan account should allow for a change in beneficiaries. These will be confirmed via email or postal mail.”
One of the benefits of beneficiary designations is that you can update them without the expense of updating your estate planning documents.
“Like any kind of estate planning, the choice of the beneficiary is generally up to the account owner, except married account owners who likely will need to provide for a spouse,” DuFault says. “Contingent beneficiaries are also important as they will receive the account if the primary (beneficiary) is deceased.”
When minors or young adults are potential beneficiaries, proper trust language should be used to avoid court-supervised control of withdrawals and distributions.
“Additionally, as part of the ongoing review of beneficiary designations, life events such as births, deaths, marriages and divorces for both the participant and the intended beneficiaries should be considered,” he adds.
[Read: Is a 401(k) Worth It in 2024? Pros, Cons and Costs]
Think Carefully When Choosing a Beneficiary
When selecting a 401(k) beneficiary, consider factors such as the beneficiary’s age and relationship, financial situation, and ability to manage the assets. “For example, if the primary beneficiary is a minor, a trust may need to be established to manage the assets until they reach the age of majority,” says Michael Collins, founder and a financial planner at WinCap Financial in Winchester, Massachusetts.
The beneficiary should be informed of their designation and given access to the necessary documents, such as the beneficiary designation form and the plan’s terms and conditions. “When the primary 401(k) holder passes away, the beneficiary should contact the plan administrator to begin receiving the assets,” Collins adds.
Owners of 401(k)s must understand the unique situations of any potential beneficiaries.
“This includes their financial literacy, their current and projected tax brackets, and how the inheritance might affect their long-term financial goals and needs,” says David Brillant, a full-service tax, trust and estate lawyer at Brillant Law in Walnut Creek, California. “It’s also essential to educate the chosen beneficiaries on their options and responsibilities to manage the inherited assets wisely.”
In doing so, beneficiaries must be made aware of the required minimum distributions and the tax implications thereof, particularly in light of the SECURE Act. “The Act has significantly altered the distribution requirements for inherited 401(k)s and IRAs,” Brillant says.
Strategically, the 401(k) plan owner should name someone who can communicate with the employer and the custodian of the assets and understand what to do next.
“If the owner is nervous about the beneficiaries inheriting a large sum or not knowing what to do, they may want to name a trust as the beneficiary,” Becker says. “Then the trustee of the trust can distribute assets to the beneficiary of the trust per the terms of the trust.”
Update Beneficiaries After Major Life Events
When you start a job in your 20s, you might list your mother, father or sibling as the beneficiaries of your account. When you marry, you usually change your beneficiary to your spouse. If you plan to leave your retirement account balance to your children, you need to update your beneficiary form upon the birth of each child.
Divorce or remarriage is another reason to change your beneficiary forms. If you remarry but leave an ex-spouse’s name on your most recent beneficiary document, your ex-spouse will inherit your remaining retirement assets.
Understand 401(k) and IRA Plan Differences
There is a difference between selecting a beneficiary for an IRA and a 401(k).
“For an IRA, the owner can designate multiple beneficiaries and specify the percentage of assets each beneficiary will receive,” Collins says. “However, with a 401(k), the owner can only designate one primary beneficiary and contingent beneficiaries. It’s also important to note that the rules for selecting beneficiaries may vary depending on the type of plan and its administrator.
Additionally, 401(k) plan holders needn’t include a plan beneficiary in their last will and testament. That’s because the named beneficiary in one’s 401(k) account at work will override any beneficiaries named in a will.
Talk to Your Beneficiary
It’s common for the beneficiary to not know their designation as a 401(k) plan beneficiary until the account holder passes away.
“That’s why it’s better if the account holder immediately makes the beneficiary aware of the appointment,” DuFault says. “Until the account holder dies, however, the beneficiary has no rights concerning the plan or the account.”
After the account holder passes, the beneficiary must contact the plan administrator or other plan official to initiate the account transfer according to the beneficiary designation. “The beneficiary should also contact their own financial planner to be sure an account has been set up to receive the plan benefits once the beneficiary claim form has been submitted and processed,” DuFault advises.
Named beneficiaries should also pay close attention to the language in the 2020 Secure Act. Under the legislation, 401(k) plan beneficiaries must withdraw all inherited 401(k) assets within 10 years of the previous plan holder’s passing.
The law does include some exceptions to that rule, such as surviving spouses, minor children, disabled or significantly ill beneficiaries, and beneficiaries who are less than 10 years younger than the original account holder.
[READ: What Is the Inherited IRA 10-Year Rule?]
Understand Tax Implications for Beneficiaries
There may be tax implications for 401(k) plan beneficiaries.
“Generally, beneficiaries are required to pay income tax on the distributions they receive from these accounts,” Collins says. “However, if the assets are transferred to a spouse, they may be able to roll over the assets into their own IRA or 401(k) and avoid immediate taxation.”
Withdrawals by a beneficiary will also be taxed at the beneficiary’s ordinary income tax rate. “If there is a need for a withdrawal, they may want to ‘gross it up’ to include the amount that will be due to the Federal and possibly State government at tax return time,” Becker notes.
Additionally, non-spouse beneficiaries may be able to transfer the assets to an inherited IRA, allowing for a longer distribution period and potentially lower tax liability. Collins says, “It’s important for beneficiaries to consult with a tax professional to understand their tax responsibilities.”
More from U.S. News
How to Create a Retirement Budget
What Are the Average Retirement Ages Around the World?
How to Maximize Social Security With Spousal Benefits
How to Pick a Beneficiary for a 401(k) Plan originally appeared on usnews.com
Update 04/18/24: This story was published at an earlier date and has been updated with new information.
