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Choosing a beneficiary for your IRA or 401(k) [UPDATED]

Published 9:19am Monday, May 20, 2013 Updated 11:23am Monday, May 20, 2013

Selecting beneficiaries for retirement benefits is different from choosing beneficiaries for other assets. With retirement benefits, you need to know 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 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.

For example, if one of your children inherits $100,000 cash from you and another child receives your 401(k) account worth $100,000, they aren’t receiving the same amount. The reason is that all distributions from the 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.

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

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.

You may name a charity as a beneficiaries, and often times they will not pay tax on the proceeds due to their tax exempt status.

This can me a good way to leave a legacy and avoid taxes on an otherwise taxed part of your estate.

When you open up an IRA or begin participating in a 401(k), you are given a form to complete in order 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.

 

Bonnie Denzel is a financial advisor with Dorn and Co., in Fergus Falls.

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