For retirement savers, adding a beneficiary to your 401(k) plan should be a top priority. A 401(k) plan beneficiary is the person or entity, such as a charity or trust, who inherits your 401(k) after your death. If a beneficiary isn’t named and the account holder dies, the 401(k) plan will likely end up in probate court to decide who receives the funds.
The primary problem is that 401(k) plan holders may not realize the importance of naming a beneficiary. More commonly, a plan holder may believe that naming a recipient in their will is sufficient, but that’s not the case.
“It’s a complicated process, much more than simply providing your will to the 401(k) company and receiving your distribution,” said Adam D’Acierno, founding partner at Strategic Capital in Austin, Texas, in an email.
How can 401(k) plan holders and beneficiaries get the transfer process right? Retirement planning experts suggest following these guidelines.
— Designate a beneficiary.
— Think carefully when choosing a beneficiary.
— Inform beneficiaries of plan options and taxes.
— Update beneficiaries after major life events.
— Avoid common 401(k) beneficiary mistakes.
Designate a Beneficiary
Designating a beneficiary for a 401(k) typically occurs when the original plan holder first enrolls or at any point afterward.
Naming a 401(k) plan beneficiary is easy to do. “Just log in to your 401(k) plan account portal and name the beneficiary,” said Travis Wesley, a chartered retirement plan specialist at Financial Investment Team in Portland, Oregon, in an email. “Typically, all that’s needed is a name and relationship to the plan participant. Additional information, such as date of birth, contact details, phone, address and email are also helpful.”
Default beneficiary designations may include these options:
— 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, the 401(k) plan assets may go to the estate, depending on state law.
There’s no rule that says a beneficiary needs to be notified right away.
“Some people want their beneficiary to know about the assets they will receive, and some do not,” D’Acierno said. “If you don’t wish to disclose that information while you are living, it’s wise to have some plan to notify your beneficiary of their status after your passing.”
Working with a financial professional and an attorney can help 401(k) account holders be transparent and helpful with plan beneficiaries, and on their terms. “That’s a great way to educate the beneficiary on the distribution rules and tax implications of their inheritance and to ensure that the assets left behind are distributed in the exact manner you wish,” D’Acierno added.
Think Carefully When Choosing a Beneficiary
Deciding on a beneficiary isn’t necessarily a cut-and-dried issue. Plan holders should give careful thought to the decision and vet potential recipients accordingly.
“When choosing a plan beneficiary, most people will elect their significant other or children,” Wesley said. “This is often the best choice for their family. They don’t have to worry about going through the probate process and involving the state courts to decide what should happen with their money.”
If you plan to leave retirement accounts to someone under 18, be aware that the IRS deems minor-aged children unable to manage financial assets and a guardian may be required. “This is another reason to consider using some of the complimentary tools that come with the 401(k), like setting up a will, power of attorney and medical directive,” Wesley said.
Plan holders can also list a trust as the beneficiary. “Upon their death, their assets will not only be distributed to the person they want, but those assets will be distributed in the manner they choose,” D’Acierno said.
Plan holders should also consider where the 401(k) assets will go if the beneficiary dies.
“This issue is often an overlooked component,” said Andrew Constantinides, a certified financial planner and investment advisor at Neil Jesani Wealth Management in Miami, in an email. “Once the assets pass to your beneficiary, they have full control to leave those assets to whomever they choose. So think about what that chain might look like.”
[Read: How to Manage an Inherited IRA.]
Inform Beneficiaries of Plan Options and Taxes
If a plan participant has already elected a beneficiary and included their contact information, the 401(k) plan administrator will attempt to reach them to disburse the assets after the original account holder passes away.
“The recipient will have the option to roll it to an account in their name based on their relationship with the participant,” Wesley noted. “Usually, a spouse will roll it over to a traditional IRA for consolidation.”
That’s not the case for kids or non-spouses. “Those recipients will have to convert the 401(k) into an inherited IRA and make sure they draw down the account within 10 calendar years from the date of death,” Wesley says.
There are no tax obligations when rolling over a 401(k) account after inheriting it. “Yet once you start taking the funds out, the pretax amount is treated as ordinary income, just like wages,” Wesley added. “If the account was a Roth 401(k) or 403(b), it was already taxed and the distributions will be tax-free.”
[Should You Spend Your Nest Egg or Leave a Legacy?]
Update Beneficiaries After Major Life Events
Timing matters when naming 401(k) plan beneficiaries.
For example, when you start a job in your 20s, you might list your mother, father or sibling as the beneficiary of your account. Later on, you may get married and start a family. At this point, you’re likely to change your beneficiary to your spouse. At some point later, you might decide to leave your retirement account balance to your children. In that scenario, you’ll 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.
“We’ve seen situations where an account holder remarries and lists their new spouse as a beneficiary of their assets in their will, but they fail to update the named beneficiary on their 401(k) account,” D’Acierno said. “That supersedes a will in most instances.”
That’s why it’s a good idea to regularly review your 401(k) plan with a financial advisor, who can help you accurately update your beneficiary plan.
Avoid These Common 401(k) Beneficiary Mistakes
The biggest blunder 401(k) account holders make is failing to elect a beneficiary. “It’s easier than picking the investments and will save your heirs from the headaches of probate or potential fighting between loved ones,” Wesley said.
Not working with a financial professional can also lead to big 401(k) planning problems.
“Our firm met with a widow who, before meeting with us, requested the wrong type of distribution from her husband’s 401(k) account and was left with a $250,000 tax bill,” D’Acierno said. “In the end, with guidance from a tax professional and help from financial professionals, she was able to remedy the situation and receive an IRS ruling to amend the transaction to eliminate the taxable liability that was created in error.”
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How to Pick a Beneficiary for a 401(k) Plan originally appeared on usnews.com
