“Designating Beneficiaries so the Gift Keeps Giving” by Christiaan D. Horton
With the new calendar year, it is always a good idea to reflect on your beneficiary designations for your various accounts including your 401(k) plans and IRA’s. Assets like bank accounts, CDs, stocks and real estate will generally pass to your named beneficiaries without income tax ramifications. Beneficiaries will pay ordinary income tax on distributions from pretax 401(k) accounts and traditional IRA’s; however, with Roth IRAs and Roth 401(k) accounts, beneficiaries can receive benefits free from income tax if all tax requirements are met. This means you must consider the impact of income taxes when designating beneficiaries on your 401(k) and IRA assets. Otherwise, your beneficiaries may not be treated “equally” as you intended after taxes are paid.
It is also wise to have multiple beneficiaries in the event that a primary beneficiary is unable to receive the benefits or declines them (disclaimer in tax lingo). That way a secondary or contingent beneficiary can receive the benefits, and the benefits can transfer as intended outside of your probate estate.
There are two primary ways your retirement benefits could end up in your probate estate. Most know that probate is the court process in which assets are transferred from someone who has died to his or her heirs or beneficiaries entitled to receive them, but it is something to be avoided, right? Most would agree.
The first way your retirement benefits could end up in your probate estate is by a direct route, the naming of your state as beneficiary, but should you do this? This raises complex tax considerations that must be seriously considered, and legal advice is always recommended with this approach. The opportunity to maximize tax deferral by spreading out distributions may be lost if your estate receives your retirement benefits.
The second avenue is indirect and often unintended. If no named beneficiary survives you, or if you do not have a properly designated beneficiary on your accounts, your probate estate may end up as the beneficiary by default. Retirement Plan documents should first be considered as they may contain provisions that designate a beneficiary by default if one is not properly named.
Normally a spousal beneficiary has the greatest flexibility for delaying distributions that are subject to income tax. Your spouse may roll over 401(k) or IRA accounts you leave behind to his or her IRA or qualified plan or may treat such accounts as his or her own which can provide more tax and planning options. The potential downside to naming your spouse as a primary beneficiary is that it may increase the size of his or her estate for estate tax purposes.
When it comes to naming your Trust as a beneficiary, beware! Special tax rules apply that can create a host of potential income tax complications as well.
With the advent of the new year, this is a great time to contact our Estate Planning Group to make sure that your beneficiary designations are set and that you are maximizing the tax advantages available to you with your estate plan.